Accounting Zoubida SAMLAL - MBA, CFA Member, PHD candidate for HBS program 1.

Accounting

Zoubida SAMLAL - MBA , CFA Member, PHD candidate for HBS program

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PLANModule chapter

Part I Introduction to accounting

Types of Accounting and RegulatorsPart II Accounting and financial systems

Recording transactions

Part III Closing Process

Introduction to Accounting and Regulators

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Fundamental concepts

What is accounting?• the language of business• a process of identifying, recording, summarizing, and reporting

economic information to decision makers in the form of financial statements

• a mean to communicate financial information.• a way to convey information about a business to users.

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Definitions of Accounting

• “The process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.”

—American Accounting Association (AAA)

• “A service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.”

—American Institute of Certified Public Accountants (AICPA)

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Primary Functions of Accounting

1. Recording data about business transactions

2. Summarizing results of business activity into useful report-

However, managers in today's environment demand more

detailed reports like sales by district or sales by product type.

3. Providing assurances that the business is operating as

intended and that the assets of the organization are protected

Accounting as an Aid to Decision Making

• Accounting helps in decision making by showing where and when money has been spent, by evaluating performance, and by showing the implications of choosing one plan instead of another.

• Fundamental relationships in the decision-making process:

EventAccountant’sanalysis and

recording

Financialstatements Users

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Who uses accounting information?• Owners• Managers• Investors (including potential)– Analysts on their behalf• Creditors (including potential)• Government (tax assessment)• Regulators• Customers

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• Accounting has two main divisions:

1- Financial accounting

Primarily prepared for users external to the company: Revenues,

earnings, assets, etc.

2- Management accounting

Primarily for internal purposes : Costing, budgeting, net present

value, etc.

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There are several ways that cash gets into a company:• Investment by owners• Investment by creditors (loans)• Payments from customers• Repayment of amounts loaned to other entities• Return on investments (interest and dividend)• Proceeds from selling assets

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Cash going in can be organized into three categories:

Operations• Payments from customers• Refunds from suppliers

Financing• Investment by owners• Investment by creditors (loans)

Investing• Return on investments (interest and dividend)• Proceeds from selling assets• Repayment of amounts loaned to other entities

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Similarly, money going out of an entity can be categorized:

Operations• Payments to suppliers• Refunds to customers

Financing• Payment of dividends or capital to owners• Repayment of creditors

Investing• Purchase of assets• Amounts invested in other entities (debt or equity)

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Financial accounting categorizes all transactions and events based

on their substance because the users of the information are using it with the assumption that these categorizations are being made accurately.

If money invested by owners was reported as revenue, this would be counter to the fundamental definition of revenue (i.e. that it results from the operations of the company).

The separation of income and capital is a fundamental concept of financial accounting.

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Standards and Regulatory bodies

Securities Act of 1933




Securities and Exchange CommissionSecurities and Exchange Commission

Established by federal government

Accounting and reporting for public companies

Encouraged private standard-setting body

SEC requires public companies to adhere to GAAP aka IFRS

Oversight

Enforcement Authority

Financial Accounting Standards BoardFinancial Accounting Standards Board

Wheat Committee’s recommendations resulted in the creation of a the Financial Accounting Standards Board (FASB) in 1973.

Financial Accounting Foundation

Financial Accounting Foundation

Selects members of the FASB Funds their activities Exercises general oversight.

Financial Accounting Standards Board

Financial Accounting Standards Board

Financial Accounting Standards Advisory Council

Financial Accounting Standards Advisory Council

Mission to establish and improve standards of financial accounting and reporting.

Consult on major policy issues.

Missions is to establish and improve standards of financial accounting and reporting. Differences between FASB and APB include:

Financial Accounting Standards BoardFinancial Accounting Standards Board

Full-time, Remunerated Membership

Greater Autonomy

Increased Independence

Broader Representation

• Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.

• Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.

• Sarbanes-Oxley Act responded to cases of accounting fraud.– Created the Public Accounting Oversight Board, which sets audit standards and

investigates and sanctions accounting firms that certify the books of publicly traded firms.

– Senior executives must personally certify that the financial information reported by the company is correct.

– Resulted in increase in demand for accountants.

Standard-Setting OrganizationsStandard-Setting Organizations

http://www.fasab.gov/accepted.html

http://www.fasb.org/

Financial Reporting ChallengesFinancial Reporting Challenges

IFRS in a Political Environment

What the public thinks accountants should do vs. what accountants think

they can do.


The Expectations Gap

Significant Financial Reporting Issues

Non-financial measurements

Forward-looking information

Sort assets

Timeliness

Ethics in the Environment of Financial Accounting

Companies that concentrate on “maximizing the bottom

line,” “facing the challenges of competition,” and

“stressing short-term results” place accountants in an

environment of conflict and pressure.

IFRS does not always provide an answer.

Doing the right thing is not always easy or obvious.


International Convergence

In 2002 the IASB and the FASB formalized their commitment

to the convergence of U.S. GAAP and international

standards. The Boards agreed to:

1. Make their existing financial reporting standards fully

converged as soon as practicable, and

2. Coordinate their future work programs to ensure that

once achieved, convergence is maintained.


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12 Fundamental concepts12 Fundamental concepts

1) BUSINESS ENTITY CONCEPT1) BUSINESS ENTITY CONCEPT

• Business is treated as separate & distinct from its members

• Separate set of books are prepared.

• Proprietor is treated as creditor of the business.

• For other business of proprietor different books are prepared.

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2) MONEY MEASUREMENT CONCEPT 2) MONEY MEASUREMENT CONCEPT

• Transactions of monetary nature are recorded.

• Transactions of qualitative nature, even though of great importance to business are not considered.

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3) GOING CONCERN CONCEPT3) GOING CONCERN CONCEPT

• Business will continue for a long period.

• As per this concept, fixed assets are recorded at their original cost & depreciation is charged on these assets.

• Because of this concept, outside parties enter into long term contracts with the enterprise.

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4) ACCOUNTING PERIOD CONCEPT4) ACCOUNTING PERIOD CONCEPT

• Entire life of the firm is divided into time intervals for ascertaining the profits/losses are known as accounting periods.

• Accounting period is of two types- financial year(1st Apr to 31st March) & calendar year(1st Jan to 31st Dec).

• For taxation purposes financial year is adopted as prescribed by the Govt.

• Companies having their shares listed on stock exchange publishes their quarterly results.

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5) HISTORICAL COST CONCEPT5) HISTORICAL COST CONCEPT

• Assets are recorded at their original price.

• This cost serves the basis for further accounting treatment of the asset.

• Acquisition cost relates to the past i.e. it is known as historical cost.

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JUSTIFICATION FOR HISTORICAL COST CONCEPT

JUSTIFICATION FOR HISTORICAL COST CONCEPT

• This cost is objectively verifiable.

• Justified by going concern concept.

• Current values are difficult to determine.

• Difficult to keep track of up down of the market price.

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DRAWBACKS OF HISTORICAL CONCEPTDRAWBACKS OF HISTORICAL CONCEPT

• Assets for which nothing is paid will not be recorded like reputation, brand value, etc.

• Information based on historical cost may not be useful to its members.

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6) DUAL ASPECT CONCEPT6) DUAL ASPECT CONCEPT

• Every transaction recorded in books affects at least two accounts.

• If one is debited then the other one is credited with same amount.

• This system of recording is known as “DOUBLE ENTRY SYSTEM”.

• ASSETS = LIABILITIES + CAPITAL

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7) REVENUE RECOGNITION/REALISATION CONCEPT

7) REVENUE RECOGNITION/REALISATION CONCEPT

• Revenue means the addition to the capital as a result of business operations.

• Revenue is realized on three basis-:1. Basis of cash2. Basis of sale3. Basis of production

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8) MATCHING CONCEPT8) MATCHING CONCEPT

• All the revenue of a particular period will be matched with the cost of that period for determining the net profits of that period.

• Accordingly, for matching costs with revenue, first revenue should be recognized & then costs incurred for generating that revenue should be recognized.

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Following points must be consideredwhile matching costs with revenue

Following points must be consideredwhile matching costs with revenue

• Outstanding expenses though not paid in cash are shown in the P&L a/c.

• Prepaid expenses are not shown in the P&L a/c.

• Closing stock should be carried over to the next period as opening stock.

• Income receivable should be added in the revenue & income received in advance should be deducted from revenue.

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9) ACCRUAL CONCEPT9) ACCRUAL CONCEPT

• In this concept revenue is recorded when sales are made or services are rendered it is immaterial whether cash is received or not.

• Same with the expenses i.e. they are recorded in the accounting period in which they assist in earning the revenues whether the cash is paid for them or not.

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10) OBJECTIVITY CONCEPT10) OBJECTIVITY CONCEPT

• Accounting transactions should be recorded in an objective manner, free from the personal bias of either management or the accountant who prepares the accounts.

• It is possible only when each transaction is supported by verifiable documents & vouchers such as cash memos, invoices.

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11) TIMELINESS11) TIMELINESS

• This principle states that the information should be provided to the users at right time for the purpose of decision making.

• Delay in providing accounts serves no usefulness for the users for decision making.

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12) COST BENEFIT PRINCIPLE12) COST BENEFIT PRINCIPLE

• This principle states that the cost incurred in applying the principles should be less than the profits derived from them.

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ACCOUNTING CONVENTIONS

ACCOUNTING CONVENTIONSACCOUNTING CONVENTIONS

• An accounting convention may be defined as a custom or generally accepted practice which is adopted either by general agreement or common consent among accountants.

1) CONVENTION OF FULL DICLOSURE1) CONVENTION OF FULL DICLOSURE

• Information relating to the economic affairs of the enterprise should be completely disclosed which are of material interest to the users.

• Proforma & contents of balance sheet & P&L a/c are prescribed by Companies Act.

• It does not mean that leaking out the secrets of the business.

2) CONVENTION OF CONSISTENCY2) CONVENTION OF CONSISTENCY

• Accounting method should remain consistent year by year.• This facilitates comparison in both directions i.e. intra firm &

inter firm.

• This does not mean that a firm cannot change the accounting methods according to the changed circumstances of the business.

3) CONVENTION OF CONSERVATISM3) CONVENTION OF CONSERVATISM

• All anticipated losses should be recorded but all anticipated gains should be ignored.

• It is a policy of playing safe.

• Provisions is made for all losses even though the amount cannot be determined with certainty

4) CONVENTION OF MATERIALITY4) CONVENTION OF MATERIALITY

• According to American Accounting Association, “An item should be regarded as material if there is reason to believe that knowledge of it would influence decision of informed investor.”

• It is an exception to the convention of full disclosure.

• Items having an insignificant effect to the user need not to be disclosed.

DIFFERENCE B/W CONCEPTS & CONVENTIONS

DIFFERENCE B/W CONCEPTS & CONVENTIONS

BASIS ACCOUNTING CONCEPTS

ACCOUNTING CONVENTIONS

Established By law Guidelines based upon customs or usage

Biasness No space for personal biasness in the adoption

Biasness in adoption

Uniformity Uniform adoption No uniform adoption

Accounting and Financial Statements

The Nature of Accounting

• The accounting system is a series of steps performed to analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their effects on an organization and to prepare the financial statements.

Accounting as an Aid toDecision Making

• Fundamental relationships in the decision-making process:

EventAccountant’s

analysis &recording

FinancialStatements

Users

Financial and Management Accounting

• The major distinction between financial and management accounting is the users of the information.– Financial accounting serves external users.– Management accounting serves internal users,

such as top executives, management, and administrators within

organizations.

Financial and Management Accounting

The primary questions about an organization’s success that decision makers want to know are:

What is the financial picture of the organization on a given day?

How well did the organization do during a given period?

CHART OF ACCOUNTS

The Chart of Accounts is organized using three different methods.

1. First: Accounting Types2. Second: Order of Liquidity - the ease

of converting to cash without loss of value

3. Third: Account Numbers

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7 TYPES OF ACCOUNTS

1. Assets - Things you own2. Liabilities - Things you owe3. Equity - Owners Stake in Company4. Revenue - Income through Sales of the Products of the Business5. Costs of Goods Sold - Costs to provide the service or to

manufacture or acquire the product the business sells6. Expenses - Things that are paid for that are consumable and are

part of the cost of running a business7. Other Revenue and Expenses - Revenue and Expenses that are

unusual cases and are not directly related to the business product and are not usual costs of running a business.

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ORDER OF LIQUIDITY

• The Chart of Accounts’ second method of organization is Order of Liquidity. Liquidity refers to the expectation that the item can be converted to cash at least close to its current value within one year.

• Accounts are listed in descending order of liquidity within their accounting types, with cash at the top of the list for Assets.

• The liquidity classification is so important that Assets and Liabilities are divided into the Subtypes of Current and Long Term/Fixed to group items of similar liquidity together.

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ACCOUNT NUMBERS

• Assigning Account numbers starts by assigning a range of numbers to each Accounting Type.

• The number of digits will be important in your software system so when using ranges in the 1000’s there are 4 digits, and the Account Numbers would range from 1000 to 9999.

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ACCOUNT NUMBERS

• Assets: 1000’s– Current Assets 1000 – 1499; Fixed Assets 1500 -1999

• Liabilities: 2000’s– Current Liabilities 2000 – 2499; Long Term Liabilities 2500 -

2999• Equity: 3000’s• Revenue: 4000’s• Costs of Goods Sold: 5000’s• Expenses: 7000’s• Other Revenue: 8000’s• Other Expenses: 9000’s

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Use of Funds (Debit) Accounting Types

• Each Accounting Type under the “Funds/Use of Funds” Category increases in value or balance with each debit (Use of Funds) transaction entry and decreases in value or balance with each credit (Source of Funds) transaction entry. Use of Funds Accounts are sometimes referred to as Debit Accounts.

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Use of Funds (Debit) Accounting Types

Positive balances for these accounts are balances where total debits > total credits to the account and their balances should show in the Debit Column.

1. Assets 2. Costs of Goods Sold 3. Expenses 4. Other Expenses

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Source of Funds (Credit) Accounting Types

• Each Accounting Type under the “Source of Funds” Category increases in value or balance with each credit (Source of Funds) transaction entry and decreases in value or balance with each debit (Use of Funds) transaction entry. Source of Funds Accounts are sometimes referred to as Credit Accounts.

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Source of Funds (Credit) Accounting Types

Positive balances for these accounts are balances where total credits > total debits to the account and their balances should show in the Credit Column.

1. Liabilities - Things you owe2. Equity - Owners’ Stake in Company3. Revenue - Income through Sales of the Products of the

Business4. Other Revenues - Revenues that are unusual cases and are

not directly related to the business product and are not usual revenues from running a business.

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FINANACIAL STATEMENTS

• Financial Statements– Income Statement– Statement of Retained Earnings– Balance Sheet– Statement of Cash Flows

• Management Discussion and Analysis• Notes to Financial Statements• Auditor's Report

ANNUAL REPORT

Financial Accounting Statements

• Income Statement - reports the results of operations for a specific period of time

• Retained Earnings Statement - reports the changes in retained earnings for a specific period of time

• Balance Sheet - reports the assets, liabilities, and stockholders’ equity at a specific date

• Statement of Cash Flows - reports the cash receipts and payments for a specific period of time

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Management Discussionand Analysis

Covers three aspects of a company: – liquidity - ability to pay near term

obligations– capital resources - fund operations and

expansions– results of operation

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Notes to Financial Statements

• Provide additional information not

included in body of statements

• Describe accounting policies or explain

uncertainties and contingencies

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Auditor's Report

• Auditor, a professional accountant who

conducts an independent examination of the

financial accounting data presented by a

company.

• Auditor gives an unqualified opinion if the

financial statements present the financial

position, results of operations, and cash flows

in accordance with GAAP.66

Statement of Cash Flows

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The Cash Flow Statement (Statement of Cash Flows) provides an overview of the way Funds move through an Entity, how they impact Overall Value and eventually reconcile with Cash Balances and determine Net Cash Flow in any given year.

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3 Types of Business Activity

• Financing• Investing• Operating

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Investing Activities

• Cash• Accounts Receivable• Prepaid Rent• Buildings, Equipment, Furniture

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Obtaining the Resources or Assets needed to operate the businessExamples of assets...

Investing Activities - Examples

• Purchase or Sale of computers, delivery trucks, furniture, buildings

• Purchase or Sale of investments

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Cash flow statement

1. Operating ActivitiesNet Income

+ Depreciation Expense (+ Increase and -Decrease in Accumulated Depreciation)

+ Increases in Current Liabilities+ Decreases in Current Assets- Increases in Current Assets- Decreases in Current Liabilities

Cash flow statement

2. Investing Activities+ Decreases in Long Term/Fixed Assets (Independent

of Accumulated Depreciation)- Increases in Long Term/Fixed Assets (Independent of

Accumulated Depreciation)

Cash flow statement

3. Financing Activities+ Increases in Long Term Liabilities/Debt- Decreases in Long Term Liabilities/Debt+ Increases in Owners’ Capital- Decreases in Owners’ Capital- Increases in Dividends

Beginning Cash Balance - Net Increase/Decrease = Ending Cash Balance


Cash Flows From Operating ActivitiesNet Income $45,104Depreciation $496Increase in Payables $1,700

————Net Cash Provided by Operating Activities $47,300

————Cash Flows From Investing ActivitiesIncrease in Fixed Assets $2,950

————Net Cash Used by Investing Activities -$2,950

————Cash Flows From Financing Activities

$0————

Net Cash Provided by Financing Activities $0————

Increase in Cash and Cash Equivalents (Net Cash Flow) $44,350Cash and Cash Equivalents at Beginning of Year $0

————Cash and Cash Equivalents at End of Year $44,350

Income Statement

Income Statement

• The Income Statement Accounting Types are Revenue, Cost of Goods Sold and Expenses. The Accounts that are not on the Income Statement are on the Balance Sheet.

• As its name suggests, the purpose of the Income Statement is to report Income. Income = Revenue - Expenses. It is almost that simple, but there is more to the Income Statement than a simple calculation.

Income Statement

Revenue-Cost of Goods Sold—————-=Gross Margin-Expenses—————-=Operating Income+Other Revenue-Other Expenses—————-=Net Income

CSU CORPORATIONIncome Statement

For the Year Ended December 31, 2008

1st- head up the statement•name of company•name of statement•period of time covered

Revenues Service revenue

$17,000



2nd - List the revenues


$17,000 Expenses

Rent expense $9,000 Insurance expense 1,000 Supplies expense 200Total expenses

10,200



3rd - List and total the expenses


$17,000 Expenses


10,200Net Income $ 6,800



4th - Subtract expenses from revenues to obtain net income.

Retained Earnings

CSU CORPORATIONRetained Earnings Statement


1st- head up the statement•name of company•name of statement•period of time covered



Retained earnings, January 1 $ 0

2nd - Start with beginning retained earnings



Retained earnings, January 1 $ 0Add: Net Income6,800 6,800

3rd - Add net income from the current year - subtotal

CSU CORPORATION Retained Earnings Statement


Retained earnings, January 1 $ 0Add: Net Income6,800 6,800Less: Dividends 0Retained earnings, December 31 $ 6,800

4th - Subtract current year’s dividends and total

Balance Sheet

The Balance SheetThe balance sheet equation:

Assets = Liabilities + Owners’ Equityor

Owners’ Equity = Assets - Liabilities

CSU CORPORATION Balance Sheet

December 31, 2008

1st- head up the statement•name of company•name of statement•date


December 31, 2008

AssetsCash $ 2,000Accounts receivable 4,000Supplies 1,800Equipment 16,000Total assets $23,800

2nd - list the assets and total


December 31, 2008

AssetsCash $ 2,000Accounts receivable 4,000Supplies 1,800Equipment 16,000Total assets $23,800Liabilities and Stockholders’ EquityLiabilities Accounts payable $ 2,000

Notes payable 5,000 Total liabilities 7,000

3rd - list the liabilities and sub-total


December 31, 2008

4th - list stockholders’ equitysubtotal. Add to liabilities,Total


December 31, 2008


Notes payable 5,000 Total liabilities 7,000Stockholders’ equity

Common stock 10,000Retained earnings 6,800

Total Stockholders’ equity 16,800Total liabilities and stockholders’ equity $23,800


December 31, 2008


Notes payable 5,000 Total liabilities 7,000

3rd - list the liabilities and sub-total


December 31, 1998

4th - list stockholders’ equitysubtotal. Add to liabilities,Total

In what order are financial statements prepared?

WHY?


$17,000 Expenses


10,200Net Income $ 6,800

CSU CORPORATION Income Statement


Net Income is needed for theStatement of Retained Earnings.

CSU CORPORATION Retained Earnings Statement


Retained earnings, January 1 $ 0Add: Net Income6,800 6,800Less: Dividends 0Retained earnings, December 31 $ 6,800

Ending Retained Earnings is neededfor the balance sheet.


December 31, 2008


Notes payable 5,000 Total liabilities 7,000Stockholders’ equity

Common stock 10,000Retained earnings 6,800

Total Stockholders’ equity 16,800Total liabilities and stockholders’ equity $23,800

Analyzing and Recording Transactions

External Transactions occur between the organization and an outside party.

Internal Transactions occur within the organization.

Analyzing and Recording Process

Exchanges of economic consideration between two parties.


Accounting process: -Identifies business transactions and events, -Analyzes and records their effects, and -Summarizes and presents information in reports and financial statements.

Steps in accounts process that focus on analyzing and recording transactions and events are: (1)Record relevant transactions and events in a journal, (2) Post journal information to ledger accounts, and(3) Prepare a trial balance.

Accounting records are informally referred as the accounting books, or simply the books.

Analyze each transaction and event from source documents


Record relevant transactions and events in a journal

Post journal information to ledger (T) accountsPrepare and analyze the

trial balance

Sales Tickets

Bank Statements

Purchase Orders

Checks

Source Documents

Bills from Suppliers

Employee EarningsRecords

An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item.

An account is a record of increases and decreases in a specific asset, liability, equity, revenue, or expense item.

The Account and its Analysis

The general ledger is a record containing all accounts used by the company.

The general ledger is a record containing all accounts used by the company.

AssetsAccountsAssetsAccountsAssetsAccountsAssetsAccountsAssetAccountsAssetAccounts =


+LiabilityAccountsLiabilityAccountsLiabilityAccountsLiabilityAccountsLiabilityAccountsLiabilityAccounts

EquityAccountsEquityAccountsEquityAccountsEquityAccountsEquityAccountsEquityAccounts

LandLand

EquipmentEquipment

BuildingsBuildings

CashCash

Notes ReceivableNotes Receivable

SuppliesSupplies

Prepaid AccountsPrepaid Accounts

Accounts ReceivableAccounts Receivable

AssetAccountsAssetAccounts

Asset Accounts

Accrued LiabilitiesAccrued Liabilities

Unearned RevenueUnearned Revenue

Notes PayableNotes Payable

Accounts PayableAccounts Payable

LiabilityAccountsLiabilityAccounts

Liability Accounts

DividendsPayableDividendsPayable

EquityAccountsEquityAccounts

RevenuesRevenues

CommonStockCommonStock

DividendsDeclaredDividendsDeclared

ExpensesExpenses

Equity Accounts

RetainedEarningsRetainedEarnings

LiabilitiesLiabilities EquityEquityAssetsAssets = +


CommonStock

CommonStock Dividends Dividends RevenuesRevenues ExpensesExpenses

+ +– –

Ledger and Chart of Accounts

The ledger is a collection of all accounts for aninformation system. A company’s size and diversity of operations affect the number of accounts needed.

The ledger is a collection of all accounts for aninformation system. A company’s size and diversity of operations affect the number of accounts needed.

The chart of accounts is a list of all accounts andincludes an identifying number for each account.The chart of accounts is a list of all accounts andincludes an identifying number for each account.

101 Cash 319 Dividends106 Accounts receivable 403 Consulting Revenues126 Supplies 406 Rental revenue128 Prepaid insurance 622 Salaries expense167 Equipment 637 Insurance expense

201 Accounts payable 640 Rent expense

236 Unearned revenue 652 Supplies expense307 Common stock 690 Utilities expense318 Retained Earnings

A T-account represents a ledger account and is a tool used to understand the effects of one or more transactions.

Debits and Credits

(Left side) (Right side)Debit Credit

T- Account

Double-Entry Accounting

NORMAL Balance

ASSETS = LIABILITIES + EQUITY DR = CR CR

Assets are on the left side of the equation; therefore, the left, or debit side is the normal balance side for assets.

Liabilities and equities are on the right side; therefore, the right, or credit side is the normal balance side for liabilities and equity.

Double-Entry Accounting

Total amount that is debited to accounts must equal the total amount credited to accounts for each transaction.

Sum of debit account balances in the ledger must equal the sum of credit account balances.

ASSETS = LIABILITIES + EQUITY ||

ASSETS = LIABILITIES + Common Stock – DIV + REV - EXP


Double-Entry AccountingNORMAL Balance

Debit Credit Debit Credit Debit Credit

ASSETS

+ - + -

LIABILITIES

- + - +

EQUITIES

- + - +

Whether a debit or a credit is an increase or decrease depends on the NORMAL Balance of the account.

RevenuesRevenues ExpensesExpensesCommonStockCommonStock

DividendsDividends__ ++ __

Debit Credit

Stock

- + - + Debit Credit

Dividends

+ - + - Debit Credit

Expenses

+ - + -Debit Credit

Revenues

- + - +

EquityEquity


Investment by owner for stock 30,000 Purchase of supplies 2,500 Consulting services revenues earned 4,200 Purchase of equipment 26,000 Collection of accounts receivable 1,900 Payment of rent 1,000

Payment of salary 700 Payment of accounts payable 900 Payment of cash dividend 200

Total increases 36,100 Total decreases 31,300 Balance 4,800

Cash

An account balance is the difference between the increases and decreases in an account.

Notice the T-Account


Journalizing & Posting Transactions

Step 1: Analyze transactions and source documents.


Step 2: Apply double-entry accounting

(Left side) (Right side)Debit Credit

T- Account

ACCOUNT NAME: ACCOUNT No.

Date Description PR Debit Credit Balance

Step 4: Post entry to ledger

GENERAL JOURNAL Page 123

Date DescriptionPost. Ref. Debit Credit

Step 3: Record journal entry

GENERAL JOURNAL Page 1Date Account Titles and Explanations PR Debit Credit2009Dec. 1 Cash 30,000

Common stock 30,000 Investment by shareholders

Dec. 2 Supplies 2,500 Cash 2,500

Purchased supplies for cash

Dollar amount of debits and credits

Dollar amount of debits and credits

Journalizing Transactions

Transaction Date

Transaction Date

Transaction explanation

Transaction explanation

Titles of Affected Accounts

Titles of Affected Accounts

CASH ACCOUNT No. 101

Date Explanation PR Debit Credit Balance

2009

Dec. 1 Initial investment 30,000 30,000 Dec. 2 Purchased supplies 2,500 27,500 Dec. 3 Purchased equipment 26,000 1,500 Dec. 10 Collection from customer 4,200 5,700

T-accounts are useful illustrations, but balance column accounts are used in practice.

Balance Column Account

GENERAL JOURNAL Page 1Date Account Titles and Explanation PR Debit Credit2009Dec. 1 Cash 30,000



Purchased store suppliesfor cash



2009

Dec. 3 Purchased equipment G1 20,000.00 ########Dec. 10 Collection from customer G1 2,200.00 ########

11 Identify the debit account in ledger.

Posting Journal Entries







2009

Dec. 1

Dec. 3 Purchased equipment G1 20,000.00 ########Dec. 10 Collection from customer G1 2,200.00 ########

22 Enter the date.


GENERAL JOURNAL Page 1Date Account Titles & Elxplanations PR Debit Credit2009Dec. 1 Cash 30,000






2009

Dec. 1 30,000

Dec. 3 Purchased equipment G1 20,000 (20,000) Dec. 10 Collection from customer G1 2,200 (17,800)

33 Enter the amount and description.








2009

Dec. 1 G1 30,000


44 Enter the journal reference.




2009

Dec. 1 G1 30,000 30,000


55 Compute the balance.

GENERAL JOURNAL Page 1Date Account Titles & Elxplanations PR Debit Credit2009Dec. 1 Cash 30,000





GENERAL JOURNAL Page 1Date Account Titles and Explanation PR Debit Credit2009Dec. 1 Cash 101 30,000






2009

Dec. 1 G1 30,000 30,000


Enter the ledger reference.66


Transaction:1Shareholders invested $30,000 in FastForward on Dec. 1.

Analyzing Transactions

Assets = + EquityCash Common

Stock30,000 30,000

LiabilitiesAnalysis:

(1) Cash 101 30,000 Common stock 301 30,000

Double entry:

(1) 30,000Cash 101

(1) 30,000Common Stock 301

Posting:


Transaction:2FastForward purchases supplies by paying $2,500 cash.

Assets = + EquityCash Supplies Common

Stock(2,500) 2,500

LiabilitiesAnalysis:

(2) Supplies 126 2,500 Cash 101 2,500

Double entry:

(2) 2,500Supplies 126

(1) 30,000 (2) 2,500Cash 101

Posting:

Transaction:3FastForward purchases equipment by paying $26,000 cash.


Assets = + EquityCash Equipment Common

Stock(26,000) 26,000

Liabilities

(3) Equipment 167 26,000 Cash 101 26,000

Double entry:

(1) 30,000 (2) 2,500(3) 26,000

Cash(3) 26,000

Equipment 167 101

Posting:

Analysis:

Transaction:4 FastForward purchases $7,100 of supplies on credit.


Assets = + EquitySupplies Accounts Payable Common

Stock7,100 7,100

Liabilities

Analysis:

(4) Supplies 126 7,100 Accounts payable 201 7,100

Double entry:

2,500 (4) 7,100

Supplies 126(4) 7,100

Accounts Payable 201

Posting:


Transaction:5FastForward provides consulting services and immediately collects $4,200 cash.

Assets = + EquityCash Revenue

4,200 4,200

Liabilities

Analysis:

(5) Cash 101 4,200 Consulting Revenue 403 4,200

Double entry:

(1) 30,000 (2) 2,500(5) 4,200 (3) 26,000

Cash(5) 4,200

Consulting Revenue 403 101

Posting:


Transaction: 6 FastForward pays $1,000 cash for December rent.

Assets = + EquityCash (Expense)

(1,000) (1,000)

Liabilities

Analysis:

(6) Rent Expense 640 1,000 Cash 101 1,000

Double entry:

(1) 30,000 (2) 2,500 (5) 4,200 (3) 26,000

(6) 1,000

Cash(6) 1,000

Rent Expense 640 101

Posting:


Transactions 7: Payment of Salaries expenses in cash Analysis: - Assets (Cash) = – Equity (Expenses)Double entry: Debit Salaries Expenses and credit Cash

Transaction 8: Provide services and rents test facilities for creditAnalysis: + Assets (Accts Receivable) = + Equity (Revenues) Double entry: Debit Accounts Receivable and Credit Consulting Revenue and Credit Rental Revenue

Transaction 9: Receipt of cash from accounts receivable Analysis: + Assets (Cash) = – Assets (Accounts Receivable)Double entry: Debit Cash and credit Accounts Receivable


Transaction 10: Payment of accounts payableAnalysis: – Assets (Cash) = – Liability (Accounts Payable) Double entry: Debit Accounts Payable and credit Cash

Transaction 11: Payment of cash dividendAnalysis: – Assets (Cash) = – Equity (Dividends)Double entry: Debit Dividends and credit Cash

Transaction 12: Receipts of cash from a customer for future consulting servicesAnalysis: + Assets (Cash) = + Liabilities (Unearned Revenue)Double entry: Debit Cash and credit Unearned Consulting Revenue


Transaction 13: Pay cash for future insurance coverageAnalysis: – Assets (Cash) = + Assets (Prepaid Insurance)Double entry: Debit Prepaid Insurance and credit Cash

Transaction 14: Purchase supplies for cash Analysis: - Assets (Cash) = + Assets (Supplies)Double entry: Debit Supplies and credit Cash

Transactions 15: Payment of utilities expenses in cashAnalysis: – Assets (Cash) = – Equity (Expenses)Double entry: Debit Utilities Expense and credit Cash

Transactions 16: Payment of salaries expenses in cashAnalysis: – Assets (Cash) = – Equity (Expenses)Double entry: Debit Salaries Expense and credit Cash

After processing its remaining transactions for December, FastForward’s Trial Balance is prepared.After processing its remaining transactions for December, FastForward’s Trial Balance is prepared.

Debits CreditsCash 4,350$

Accounts receivable - Supplies 9,720 Prepaid Insurance 2,400

Equipment 26,000 Accounts payable 6,200$ Unearned consulting revenue 3,000

Common stock 30,000 Dividends 200 Consulting revenue 5,800 Rental revenue 300 Salaries expense 1,400 Rent expense 1,000 Utilities expense 230

Total 45,300$ 45,300$

FastForwardTrial Balance

December 31, 2009 The trial balance lists all account balances in the general ledger. If the books are in balance, the total debits will equal the total credits.

The trial balance lists all account balances in the general ledger. If the books are in balance, the total debits will equal the total credits.

Six Steps for Searching for and Correcting Errors

If the trial balance does not balance, the error(s) must be found and corrected.

Make sure the trial balance columns are correctly added.Make sure the trial balance columns are correctly added.

Make sure account balances are correctly entered from the ledger.

Make sure account balances are correctly entered from the ledger.

See if debit or credit accounts are mistakenly placed on the trial balance.

See if debit or credit accounts are mistakenly placed on the trial balance.

Recompute each account balance in the ledger.Recompute each account balance in the ledger.

Verify that each journal entry is posted correctly.Verify that each journal entry is posted correctly.

Verify that each original journal entry has equal debits and credits.

Verify that each original journal entry has equal debits and credits.

Using a Trial Balance to Prepare Financial Statements


Income StatementStatement of Retained Earnings

Beginning Balance Sheet

Ending Balance Sheet

Period of TimePoint inTime

Point inTime

Income Statement

Revenues: Consulting revenue 5,800$ Rental revenue 300 Total revenues 6,100$ Expenses: Salaries expense 1,400 Rent Expense 1,000 Utilities Expense 230 Total expenses 2,630 Net income 3,470$

FASTFORWARDIncome Statement

For the Month Ended December 31, 2009

Statement of Retained Earnings

Balance, 12/1/09 -$ Net income for December 3,470

3,470 Less: Dividends (200) Balance, 12/31/09 3,270$

FASTFORWARDStatement of Retained Earnings


Revenues: Consulting revenue 5,800$ Rental revenue 300 Total revenues 6,100$ Expenses: Rent expense 1,000 Salaries expense 1,400 Utilities expense 230 Total expenses 2,630 Net income 3,470$

FASTFORWARDIncome Statement


Balance Sheet

AssetsCash 4,350$ Supplies 9,720 Prepaid insurance 2,400 Equipment 26,000 Total assets 42,470$

LiabilitiesAccounts payable 6,200$ Unearned revenue 3,000 Total liabilities 9,200

EquityCommon stock 30,000 Retained earnings 3,270 Total equity 33,270 Total liabilities and equity 42,470$

FASTFORWARDBalance Sheet

December 31, 2009

Balance, 12/1/09 -$ Net income for December 3,470

3,470 Less: Dividends 200 Balance, 12/31/09 3,270$

FASTFORWARDStatement of Retained Earnings


Completing the Accounting Cycle

• multiple-column form used for the adjustment process and preparing financial statements

• working tool for the accountant• not a permanent accounting record• Eases preparation of adjusting entries

and financial statements

What is a Worksheet?

Example of a Work Sheet

Remember:

• A work sheet is not a permanent accounting record

• When it is used:– financial statements are prepared from the

work sheet– adjustments are journalized and posted from

the work sheet after financial statements, so management can receive the financial statements more quickly

To Prepare A Work Sheet:

1 Prepare the trial balance 2 Enter adjustments in the adjustments columns3 Enter adjusted balances in adjusted trial balance

columns4 Extend adjusted trial balance amounts to the

appropriate financial statement columns5 Total the statement columns, compute net income

(loss), and complete the work sheet

Dr. Cr. Dr. Cr. Dr. Cr.

Cash 3,950 Accounts receivable - Supplies 9,720 Prepaid insurance 2,400 Equipment 26,000 Accum. depr. - Equip. - Accounts payable 6,200 Salaries payable - Unearned revenue 3,000 C. Taylor, Capital 30,000 C. Taylor, Withdrawals 600 Consulting revenue 5,800

Rental revenue 300 Depr. expense - Salaries expense 1,400 Insurance expense - Rent expense 1,000 Supplies expense - Utilities expense 230 Totals 45,300 45,300

AdjustedTrial BalanceAdjustments

UnadjustedTrial Balance

FastForwardWork Sheet

For Month Ended December 31, 2011

First, enter the

unadjusted trial balance amounts to

the worksheet!

First, enter the

unadjusted trial balance amounts to

the worksheet!

Here are our adjusting entries for December

a) Insurance expense 100Prepaid insurance

100b) Supplies expense 1050

Supplies 1050

c) Depreciation expense 375Accum. Depr. – Equip.

375

Here Are More Adjusting Entries for December

d) Unearned revenue 250Consulting Revenue 250

e) Salaries Expense 210Salaries Payable 210

f) Accounts Receivable 1,800Consulting Revenue 1,800


Cash 3,950 Accounts receivable - f 1,800 Supplies 9,720 b 1,050 Prepaid insurance 2,400 a 100 Equipment 26,000 Accum. depr. - Equip. - c 375 Accounts payable 6,200 Salaries payable - e 210 Unearned revenue 3,000 d 250 C. Taylor, Capital 30,000 C. Taylor, Withdrawals 600 Consulting revenue 5,800 d 250

f 1,800

Rental revenue 300 Depr. expense - c 375 Salaries expense 1,400 e 210 Insurance expense - a 100 Rent expense 1,000 Supplies expense - b 1,050 Utilities expense 230 Totals 45,300 45,300 3,785 3,785



Next, enter the adjustments!

Next, enter the adjustments!




Cash 3,950 3,950 Accounts receivable - f 1,800 1,800 Supplies 9,720 b 1,050 8,670 Prepaid insurance 2,400 a 100 2,300 Equipment 26,000 26,000 Accum. depr. - Equip. - c 375 375 Accounts payable 6,200 6,200 Salaries payable - e 210 210 Unearned revenue 3,000 d 250 2,750 C. Taylor, Capital 30,000 - 30,000 C. Taylor, Withdrawals 600 600 Consulting revenue 5,800 d 250 7,850

f 1,800

Rental revenue 300 300 Depr. expense - c 375 375 Salaries expense 1,400 e 210 1,610 Insurance expense - a 100 100 Rent expense 1,000 1,000 Supplies expense - b 1,050 1,050 Utilities expense 230 230 Totals 45,300 45,300 3,785 3,785 47,685 47,685



Prepare the adjusted trial

balance!

Prepare the adjusted trial

balance!





Then, extend the adjusted trial balance amounts to the financial statements!

Then, extend the adjusted trial balance amounts to the financial statements!


Cash 3,950 3,950 Accounts receivable 1,800 1,800 Supplies 8,670 8,670 Prepaid insurance 2,300 2,300 Equipment 26,000 26,000 Accum. depr. - Equip. 375 375 Accounts payable 6,200 6,200 Salaries payable 210 210 Unearned revenue 2,750 2,750 C. Taylor, Capital 30,000 30,000 C. Taylor, Withdrawals 600 600 Consulting revenue 7,850 7,850

Rental revenue 300 300 Depr. expense 375 375 Salaries expense 1,610 1,610 Insurance expense 100 100 Rent expense 1,000 1,000 Supplies expense 1,050 1,050 Utilities expense 230 230 Totals 47,685 47,685 4,365 8,150 43,320 39,535

Balance Sheet &Statement of EquityStatement

AdjustedTrial Balance

Income


Cash 3,950 3,950 Accounts receivable 1,800 1,800 Supplies 8,670 8,670 Prepaid insurance 2,300 2,300 Equipment 26,000 26,000 Accum. depr. - Equip. 375 375 Accounts payable 6,200 6,200 Salaries payable 210 210 Unearned revenue 2,750 2,750 C. Taylor, Capital 30,000 30,000 C. Taylor, Withdrawals 600 600 Consulting revenue 7,850 7,850

Rental revenue 300 300 Depr. expense 375 375 Salaries expense 1,610 1,610 Insurance expense 100 100 Rent expense 1,000 1,000 Supplies expense 1,050 1,050 Utilities expense 230 230 Totals 47,685 47,685 4,365 8,150 43,320 39,535

Net income 3,785 3,785 8,150 8,150 43,320 43,320

Balance Sheet &Statement of EquityStatement

AdjustedTrial Balance

Income



Total statement columns, compute income or loss, and balance columns.

Total statement columns, compute income or loss, and balance columns.

FastForwardIncome Statement

For the Month Ended December 31, 2011Revenues: Consulting revenue 7 850$ Rental revenue 300 Total revenues 8 150 Operating expenses: Depr. expense - Equip. 375$ Salaries expense 1 610 Insurance expense 100 Rent expense 1 000 Supplies expense 1 050 Utilities expense 230 Total expenses 4 365 Net income 3 785$

Prepare the IncomeStatement.

Prepare the Financial Statements

A work sheet does not

substitute for financial

statements.

A work sheet does not

substitute for financial

statements.

Prepare the Statement of Changes in Owner’s Equity.

FastForwardIncome Statement

For the Month Ended December 31, 2011Revenues: Consulting revenue 7 850$ Rental revenue 300 Total revenues 8 150 Operating expenses: Depr. expense - Equip. 375$ Salaries expense 1 610 Insurance expense 100 Rent expense 1 000 Supplies expense 1 050 Utilities expense 230 Total expenses 4 365 Net income 3 785$ FastForward

Statement of Changes in Owner's EquityFor the Month Ended December 31, 2011

C. Taylor, Capital 12/1/04 $ -0-Add: Net income 3 785$ Investment by owner 30 000 33 785 Total 33 785 Less: Withdrawal by owner 600 C. Taylor, Capital 12/31/04 33 185$

FastForwardBalance Sheet

December 31, 2011

AssetsCash 3 950$ Accounts receivable 1 800 Supplies 8 670 Prepaid insurance 2 300 Equipment 26 000$ Less: accum. depr. (375) 25 625 Total assets 42 345$

LiabilitiesAccounts payable 6 200$ Salaries payable 210 Unearned consulting revenues 2 750 Total liabilities 9 160$

Owner's EquityC.Taylor, Capital 33 185 Total liabilities and equity 42 345$

Prepare the Balance Sheet.

FastForwardStatement of Changes in Owner's EquityFor the Month Ended December 31, 2011

C. Taylor, Capital 12/1/04 $ -0-Add: Net income 3 785$ Investment by owner 30 000 33 785 Total 33 785 Less: Withdrawal by owner 600 C. Taylor, Capital 12/31/04 33 185$

Which of these characteristics are true about a work sheet?

– a permanent accounting record– an optional device used by accountants– a part of the general ledger– a part of the journal

Answer!

– permanent accounting record– optional device used by accountants– part of the general ledger– part of the journal

Although it’s optional, the work sheet is a very useful tool!

TEMPORARY VS. PERMANENT ACCOUNTS

TEMPORARY (NOMINAL) PERMANENT (REAL) These accounts are closed These accounts are not closed

All revenue accounts All asset accounts All expense accounts All liability accounts

Owner’s drawing Owner’s capital account

Now, let’s talk about closing entries and income summary!

CLOSING ENTRIES

• Closing entries – Transfer net income (loss) and owner’s drawings to

owner’s capital– Journalizing and posting is a required step in the

accounting cycle

• Income Summary– A temporary account– Used in closing revenue and expense accounts– Minimizes the details in the permanent owner’s capital

account

Closing Process

• Resets revenue, expense and withdrawal account balances to zero at the end of the period.

• Helps summarize a period’s revenues and expenses in the Income Summary account.

Identify accounts for closing.

Record and post closing entries.

Prepare post-closing trial balance.

Temporary Accounts

Revenues

Income Summary

Expe

nses

Withdraw

als

Permanent Accounts

Assets

Liab

ilitie

s Ow

ner’s Capital

The closing process applies only to

temporary accounts.

The closing process applies only to

temporary accounts.

Temporary and Permanent Accounts

Let’s see how the closing process

works!

Recording Closing Entries

Close Revenue accounts to Income Summary.

Close Expense accounts to Income Summary.

Close Income Summary account to Owner’s Capital.

Close Withdrawals to Owner’s Capital.

Close Revenue accounts to Income Summary.

Close Expense accounts to Income Summary.

Close Income Summary account to Owner’s Capital.


Balances before closing.

Income Summary

Owner's Capital30,000

30,000

Revenue Accounts25,000

25,000

Withdrawals Account5,000

5,000

Expense Accounts10,000

10,000

Closing Process

Income Summary25,000

25,000

Close Revenue accounts to Income

Summary.

Owner's Capital30,000

30,000

Revenue Accounts25,000 25,000

-


5,000

Expense Accounts10,000

10,000

Closing Process

Income Summary10,000 25,000

15,000 Owner's Capital30,000

30,000


-


5,000

Close Expense accounts to Income

Summary.

Expense Accounts10,000 10,000

-

Closing Process

The balance in Income Summary equals net

income.

The balance in Income Summary equals net

income.

Owner's Capital30,000 15,000

45,000


45,000


5,000


5,000

Close Income Summary to Owner’s

Capital.


-


-

Income Summary10,000 25,000 15,000

-

Closing Process


45,000


15,000

40,000


5,000

Withdrawals Account5,000 5,000

-


-


-

Income Summary10,000 25,000 15,000

-

Closing Process

Close Withdrawals account to Owner’s

Capital.

FastForwardAdjusted Trial Balance

December 31, 2011Cash 3 950$ Accounts receivable 1 800 Supplies 8 670 Prepaid insurance 2 300 Equipment 26 000 Accumulated depreciation-Equip. 375$ Accounts payable 6 200 Salaries payable 210 Unearned consulting revenue 2 750 C. Taylor, Capital 30 000 C. Taylor, Withdrawals 600 Consulting revenue 7 850 Rental revenue 300 Depreciation expense-Equipment 375 Salaries expense 1 610 Insurance expense 100 Rent expense 1 000 Supplies expense 1 050 Utilities expense 230 Totals 47 685$ 47 685$

Using the adjusted trial balance, let’s prepare the

closing entries for

FastForward.

Close Revenue accounts to

Income Summary.



Close Revenue Accounts to Income Summary

Dec. 31 Consulting revenue 7,850 Rental revenue 300

Income summary 8,150

Now, let’s look at the ledger accounts after posting this closing entry.


Close Expense Accounts to Income Summary

Dec. 31 Income summary 4,365Depreciation expense-Equipment 375Salaries expense 1,610Insurance expense 100Rent expense 1,000Supplies expense 1,050Utilities expense 230

Income Summary4,365 7,850

300 3,785

Utilities Expense230 230

-

Rent Expense1,000 1,000

-

Net Income



Supplies Expense1,050 1,050

-

Depreciation Expense- Eq.

375 375 -

Salaries Expense1,610 1,610

-

Insurance Expense100 100

-

Close Income Summary to

Owner’s Capital.




Close Income Summary to Owner’s Capital

Dec. 31 Income summary 3,785C. Taylor, Capital 3,785

C. Taylor, Capital30,000 3,785

33,785




Income Summary4,365 7,850 3,785 300

-


Close Withdrawals to Owner’s Capital

Dec. 31 C. Taylor, Capital 600C. Taylor, Withdrawals 600

C. Taylor, Capital600 30,000

3,785

33,185

C. Taylor, Withdrawals

600 600

-



ABOUT CLOSING ENTRIES

Be Careful!•Avoid doubling revenue and expense balances – watch debits and credits•Remember: owner’s drawing does not move to the Income Summary account. Owner’s drawing is not an expense and it is not a factor in determining net income.

RESULTS OF POSTING CLOSING ENTRIES

• Temporary accounts– All temporary accounts will have zero balances after

posting the closing entries– Temporary accounts (revenues and expenses) are

totaled, balanced and double ruled• Owner’s capital

– Total equity of the owner at the end of the accounting period

– No entries are journalized and posted to owner’s capital during the year

• Permanent accounts (assets, liabilities, and owner’s capital) are not closed

POST-CLOSING TRIAL BALANCE

After all closing entries have been journalized the post-closing trial balance is prepared from the ledger.

The purpose of this trial balance is to prove the equality of the permanent account balances that are carried forward into the next accounting period.

Let’s look at FastForward’s post-

closing trial balance.

Post-Closing Trial Balance

• List of permanent accounts and their balances after posting closing entries.

• Total debits and credits must be equal.

• List of permanent accounts and their balances after posting closing entries.

• Total debits and credits must be equal.

FastForwardPost-Closing Trial Balance

December 31, 2011Cash 3 950$ Accounts receivable 1 800 Supplies 8 670 Prepaid insurance 2 300 Equipment 26 000 Accumulated depreciation-Equipment 375$ Accounts payable 6 200 Salaries payable 210 Unearned consulting revenue 2 750 C.Taylor, Capital 33 185 Totals 42 720$ 42 720$

Post-Closing Trial Balance

Post-closing Trial BalancePost-closing Trial Balance

Summary of Steps in the Accounting Cycle

1 Analyze business transactions2 Journalize the transactions3 Post to ledger accounts4 Prepare a trial balance5 Journalize and post adjusting

entries

STEPS IN THE ACCOUNTING CYCLE

6 Prepare an adjusted trial balance7 Prepare financial statements: Income

Statement, Owner’s Equity Statement, Balance Sheet

8 Journalize and post closing entries9 Prepare a post-closing trial balance

1. Correcting Entries

• Correcting Entries – errors should be corrected as soon as discovered – correcting entries are unnecessary if records are free of

errors

– can be journalized and posted whenever an error is discovered

– involve any combination of balance sheet and income statement accounts

Illustrative Example Of Correcting Entry

Incorrect Entry May 10

(To record collection from customer an account)

Correct Entry 10

(To record collection from customer an account)

Correcting Entry 20

(To correct entry of May 10)

Cash 50 Service Revenue 50

Cash 50 Accounts Receivable 50

Service Revenue 50 Accounts Receivable 50

Another Illustrative Example Of Correcting Entry

Incorrect Entry May 18

(To record purchase of equipment on account)

Correct Entry 18

(To record purchase of equipment on account)

Correcting Entry June 3

(To correct entry of May 18)

Delivery Equipment 45 Accounts Payable 45

Office Equipment 450 Accounts Payable 450

Office Equipment 450 Delivery Equipment 45 Accounts Payable 405

Question: The closing entry process consists of closing:

– all asset and liability accounts– out the owner's capital account– all permanent accounts– all temporary accounts

Which answer is correct?

The closing entry process consists of closing

– all asset and liability accounts– out the owner's capital account– all permanent accounts– all temporary accounts

Standard Balance Sheet Classifications

• Financial statements become more useful when the elements are classified into significant subgroups.• A classified balance sheet generally has the

following standard classifications (see next slide):

Categories of a Classified Balance SheetAssets Liabilities and Equity

Current Assets Current LiabilitiesNoncurrent Assets Noncurrent Liabilities

Long-Term Investments EquityPlant AssetsIntangible Assets

Current items are those expected to come due (both collected and owed) within the longer of one year or the

company’s normal operating cycle.

Classified Balance Sheet

Snowboarding ComponentsBalance Sheet

December 31, 2011

Current assets Cash 6 500$ Short-term investments 2 100 Accounts receivable 4 400 Merchandise inventory 27 500 Prepaid expenses 2 400 Total current assets 42 900$ Long-term investments Notes receivable 1 500 Investments in stocks and bonds 18 000 Land held for future expansion 48 000 Total investments 67 500 Plant assets Store equipment 33 200$ Less accumulated depreciation 8 000 25 200 Buildings 170 000 Less accumulated depreciation 45 000 125 000 Land 73 200 Total plant assets 223 400 Intangible assets 10 000 Total assets 343 800$

ASSETS

Current assets are expected to be sold, collected, or used within one year or the

company’s operating cycle.


December 31, 2011


ASSETS

Long-term investments are expected to be held for the longer of one year or the

operating cycle.


December 31, 2011


ASSETS

Plant assets are tangible long-lived assets used to produce or sell products

and services.


December 31, 2011


ASSETS

Intangible assets are long-term resources used to produce or sell

products and services and that lack physical form.

Current liabilities are obligations due within the longer of one year or the company’s

operating cycle.


December 31, 2011

Current liabilities Accounts payable 15 300$ Wages payable 3 200 Notes payable 3 000 Current portion of long-term liabilities 7 500 Total current liabilities 29 000$ Long-term liabilities: Notes payable (net of current portion) 150 000 Total liabilities 179 000$

T. Hawk, Capital 164 800 Total liabilities and equity 343 800$

LIABILITIES

EQUITY

Long-term liabilities are obligations not due within the longer of one year or the

company’s operating cycle.


December 31, 2011



LIABILITIES

EQUITY

Equity is the owner’s claim on the assets.


December 31, 2011



LIABILITIES

EQUITY

Cash Flow and Financial Planning

Learning Goals

1. Tax depreciation procedures and the effect of depreciation on the firm’s cash flows.

2. Firm’s statement of cash flows, operating cash flow, and free cash flow.

3. The financial planning process, 1. long-term (strategic) financial plans2. short-term (operating) plans.

4. Cash-planning process and the cash budget.5. Pro forma income statement and balance sheet

Analyzing the Firm’s Cash Flows

• Cash flow is the primary focus of the financial manager.

• An important factor affecting cash flow is depreciation.

• From an accounting perspective - statement of cash flows.

• From a financial perspective,

– Managerial decision-making - operating cash flow

– Participants in the capital market - free cash flow

Depreciation

• Depreciation is the systematic charging of a portion of the costs of fixed assets against annual revenues over time.

• Depreciation for tax purposes - the modified accelerated cost recovery system (MACRS).

• Other depreciation methods are often used for reporting purposes.

Depreciation: Depreciation & Cash Flow

• Financial managers are much more concerned with cash flows rather than profits.

• To adjust the income statement to show cash flows from operations, all non-cash charges should be added back to net profit after taxes.

• By lowering taxable income, depreciation and other non-cash expenses create a tax shield and enhance cash flow.

Depreciation: MACRS Depreciable Value & Depreciable Life

• The depreciable value of an asset is its full cost, including outlays for installation.

• No adjustment is required for expected salvage value.

• For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period.

• MACRS property classes and rates are shown in Table 3.1 and Table 3.2 on the following slides.

Depreciation

First Four Property Classes under MACRS

Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes

Depreciation: An Example

• Baker Corporation acquired, for an installed cost of $40,000, a machine having a recovery period of 5 years. Using the applicable MACRS rates, the depreciation expense each year is as follows:

Depreciation

• Question:– If as a business owner you could design a depreciation

schedule to look the way you wanted it to, what would it look like?

Developing the Statement of Cash Flows

• The statement of cash flows summarizes the firm’s cash flow over a given period of time.

• The statement of cash flows is divided into three sections:– Operating flows– Investment flows– Financing flows

Developing the Statement of Cash Flows: Classifying Inflows and Outflows of Cash

• The statement of cash flows essentially summarizes the inflows and outflows of cash during a given period.

Inflows and Outflows of Cash

Baker Corporation Income Statement ($000) for the Year Ended December 31, 2009

Baker Corporation Balance Sheets ($000) (cont.)

Baker Corporation Balance Sheets ($000)

Baker Corporation Statement of Cash Flows ($000) for the Year Ended December 31,

2009

Interpreting Statement of Cash Flows

• The net increase (or decrease) in cash and marketable securities should be equivalent to the difference between the cash and marketable securities on the balance sheet at the beginning of the year and the end of the year.

NOPAT = EBIT x (1 – T)

OCF = NOPAT + Depreciation

OCF = [EBIT x (1 – T)] + Depreciation

Operating Cash Flow

• A firm’s Operating Cash Flow (OCF) is the cash flow a firm generates from normal operations—from the production and sale of its goods and services.

• OCF may be calculated as follows:

OCF = [$370 x (1 - .40) + $100 = $322

Operating Cash Flow (cont.)

• Substituting for Baker Corporation, we get:

• Thus, we can conclude that Baker’s operations are generating positive operating cash flows.

FCF = OCF – NFAI - NCAI

NFAI = Change in net fixed assets + Depreciation

NCAI = Change in CA – Change in A/P and Accruals

Free Cash Flow

• Free Cash Flow (FCF) is the amount of cash flow available to debt and equity holders after meeting all operating needs and paying for its net fixed asset investments (NFAI) and net current asset investments (NCAI).

• Where:

FCF = $322 – $300 - $0 = $22

NFAI = [($1,200 - $1,000) + $100] = $300

NCAI = [($2,000 - $1,900) + ($800 - $700)] = $0

Free Cash Flow (cont.)

• Using Baker Corporation we get:

• This FCF can be used to pay its creditors and equity holders.

The Financial Planning Process

• Financial planning involves guiding, coordinating, and controlling the firm’s actions to achieve its objectives.– cash planning and profit planning.

• Cash planning involves the preparation of the firm’s cash budget.

• Profit planning involves the preparation of both cash budgets and pro forma financial statements.

The Financial Planning Process: Long-Term (Strategic) Financial Plans

• Long-term strategic financial plans lay out a company’s planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years.

The Financial Planning Process: Long-Term (Strategic) Financial Plans (cont.)

• Long-term financial plans consider a number of financial activities including:– Proposed fixed asset investments– Research and development activities– Marketing and product development– Capital structure – Sources of financing

• These plans are generally supported by a series of annual budgets and profit plans.

Short-Term FinancialPlanning

Cash Planning: Cash Budgets

• The cash budget or cash forecast is a statement of the firm’s planned inflows and outflows of cash.

• It is used to estimate short-term cash requirements with particular attention to anticipated cash surpluses and shortfalls.

• Surpluses must be invested and deficits must be funded.

Cash Planning: Cash Budgets (cont.)

• The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period.

Cash Planning: Cash Budgets (cont.)

The General Format of the Cash Budget

Cash Planning: Cash Budgets An Example: Coulson Industries

• Coulson Industries, a defense contractor, is developing a cash budget for October, November, and December. Halley’s sales in August and September were $100,000 and $200,000 respectively. Sales of $400,000, $300,000 and $200,000 have been forecast for October, November, and December. Historically, 20% of the firm’s sales have been for cash, 50% have been collected after 1 month, and the remaining 30% after 2 months. In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

Cash Planning: Cash Budgets An Example: Coulson Industries (cont.)

• Based on this information, we are able to develop the following schedule of cash receipts for Coulson Industries.

A Schedule of Projected Cash Receipts for Coulson Industries ($000)


• Coulson Company has also gathered the relevant information for the development of a cash disbursement schedule. Purchases will represent 70% of sales—10% will be paid immediately in cash, 70% is paid the month following the purchase, and the remaining 20% is paid two months following the purchase. The firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and a portion of the principal on its loans. The resulting disbursement schedule thus follows.

Schedule of Projected Cash Disbursements for Coulson Industries ($000)


• The Cash Budget for Coulson Industries can be derived by combining the receipts budget with the disbursements budget. At the end of September, Coulson’s cash balance was $50,000, notes payable was $0, and marketable securities balance was $0. Coulson also wishes to maintain a minimum cash balance of $25,000. As a result, it will have excess cash in October, and a deficit of cash in November and December. The resulting cash budget follows.

A Cash Budget for Coulson Industries ($000)

Profit Planning: Pro Forma Statements

• Pro forma financial statements are projected, or forecast, financial statements – income statements and balance sheets.

Profit Planning: Pro Forma Financial Statements

Profit Planning: Pro Forma Financial Statements (cont.)

Vectra Manufacturing’s Balance Sheet, December 31, 2009


• Step 1: Start with a Sales Forecast– The first and key input for developing pro forma financial

statements is the sales forecast for Vectra Manufacturing.

2010 Sales Forecast for Vectra Manufacturing

• Step 1: Start with a Sales Forecast (cont.)– The previous sales forecast is based on an increase

in price from $20 to $25 per unit for Model X and from $40 to $50 per unit for Model Y.

– These increases are required to cover anticipated increases in various costs, including labor, materials, & overhead.


• Step 2: Preparing the Pro Forma Income Statement– A simple method for developing a pro forma income

statement is the “percent-of-sales” method.



A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Vectra Manufacturing for the Year Ended December 31, 2010

• Step 2: Preparing the Pro Forma Income Statement (cont.)

– Clearly, some of the firm’s expenses will increase with the level of sales while others will not.

– As a result, the strict application of the percent-of-sales method is a bit naïve.

– The best way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components.

– This may be demonstrated as follows.


• Step 3: Preparing the Pro Forma Balance Sheet– Probably the best approach to use in developing the pro

forma balance sheet is the judgmental approach.

– Under this simple method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account.


• Step 3: Preparing the Pro Forma Balance Sheet (cont.)

1. A minimum cash balance of $6,000 is desired.

2. Marketable securities will remain at their current level of $4,000.

3. Accounts receivable will be approximately $16,875 which represents 45 days of sales on average [(45/365) x $135,000].

4. Ending inventory will remain at about $16,000. 25% ($4,000) represents raw materials and 75% ($12,000) is finished goods.

5. A new machine costing $20,000 will be purchased. Total depreciation will be $8,000. Adding $20,000 to existing net fixed assets of $51,000 and subtracting the $8,000 depreciation yields a net fixed assets figure of $63,000.


• Step 3: Preparing the Pro Forma Balance Sheet (cont.)6. Purchases will be $40,500 which represents 30% of annual sales (30% x

$135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) x $40,500].

7. Taxes payable will be $455 which represents one-fourth of the 1998 tax liability.

8. Notes payable will remain unchanged at $8,300.

9. There will be no change in other current liabilities, long-term debt, and common stock.

10. Retained earnings will change in accordance with the pro forma income statement.



A Pro Forma Balance Sheet, Using the Judgmental Approach, for Vectra Manufacturing (December 31, 2010)

Accounting Zoubida SAMLAL - MBA, CFA Member, PHD candidate for HBS program 1.

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