FINANCIAL ACCOUNTING

BASICS

P. ACCOUNTING CYCLE

1. The entire process of accounting for transactions and preparing financial statements is known as the accounting cycle. This process is repeated each accounting period.

2. Some companies prepare monthly financial statements and complete this cycle each month; other companies prepare quarterly financial statements; and some companies prepare only annual financial statements.

P. ACCOUNTING CYCLE (cont)

Preparation of Monthly Financial Statements

During the month:

1. Analyze transactions and prepare journal entries

2. Post journal entries to the ledger (we have done this using T-accounts)

End of month:

3. Prepare adjusting entries to accrue non-cash expenses and revenues (accruals and prepayments)

4. Prepare a trial balance to verify that: Total debits = Total credits

if not, then the balance sheet will not balance; we need to go back and find the journal entry in which debits did not equal credits and correct that error

5. Prepare financial statements

6. Close revenue and expense accounts to retained earnings

P. ACCOUNTING CYCLE (cont)

Example – ABC Company

We have already completed steps 1 and 2 during the month for ABC Company for the month of January, Year 1.

No adjusting entries are needed at January 31, Year 1. ABC Company does not have any accruals or prepayments that need to be recorded in January, Year 1.

The next step is to prepare a Trial Balance.

ABC Company – Ledger Balances

+ Cash - + Inventory -

- Note Payable +

- Paid-in Capital +

- Retained Earnings +

+ Accts Rec -

- Accts Payable +

10,000 10,000

5,000

5,0008,000

8,000

5,000

2,000

4,000

- Sales Revenue + + COGS Expense -

2,0002,500

2,5008,000

8,000 4,0005,000

5,000

5,000

2,000

0

14,500

10,000

5,0007,500 6,000 0

Trial Balance

ABC Company’s trial balance (pre-closing) at the end of January,

Year 1: ABC Company January 31, Year 1 Trial Balance

Account Debit CreditCash 14,500Inventory 2,000Note payable 5,000Paid-in capital 10,000Retained earnings 0Sales revenue 7,500Cost-of-goods-sold expense 6,000 0 Total 22,500 22,500

Note that total debits ($22,500) = total credits ($22,500).

Note also that Retained earnings has a balance of zero because the revenue and expense accounts have not yet been closed to retained earnings.

Prepare Income Statement and Retained Earnings Statement

ABC Company’s financial statements for the month of January, Year 1 are shown below.

Income Statement

Retained Earnings Statement

ABC CompanyIncome Statement

For the period January 1–31, Year 1

Sales revenue$7,500

Cost of goods sold expense 6,000

Income$1,500

ABC CompanyRetained Earnings Statement

For the period January 1–31, Year 1

Retained earnings, January 1 $ 0

Income, January 1,500

Dividends, January 0

Retained earnings, January 31$1,500

ABC Company – Ledger Balances (Post-closing)

+ Cash - + Inventory -

- Note Payable +

- Paid-in Capital +

- Retained Earnings +

+ Accts Rec -

- Accts Payable +

10,000 10,000

5,000

5,0008,000

8,000

5,000

2,000

4,000

- Sales Revenue + + COGS Expense -

2,0002,500

2,5008,000

8,000 4,0005,000

5,000

5,000

2,000

0

14,500

10,000

5,0007,500 6,000 0 7,500 6,000

6,000 7,500

0 0

1,500

Post-Closing Trial Balance

This is what the trial balance will look like after the Sales revenue and Cost-of-goods-sold expense accounts have been closed to Retained earnings:

ABC Company January 31, Year 1 Post-Closing Trial Balance

Account Debit CreditCash 14,500Inventory 2,000Note payable 5,000Paid-in capital 10,000Retained earnings 1,500Sales revenue 0Cost-of-goods-sold expense 0 0 Total 16,500 16,500

Prepare Balance Sheet

Balance Sheet

ABC CompanyBalance Sheet

January 31, Year 1

Assets Liabilities and EquityCash $14,500 Note payable $ 5,000Inventory 2,000 Total liabilities 5,000 Total assets $16,500 Paid-in capital 10,000

Retained earnings 1,500 Total liab & equity $16,500

Prepare Statement of Cash Flows

The Statement of Cash Flows is prepared last.

This statement summarizes the inflows and outflows of cash that occurred during the period, classifying cash flow activities as:

(1) operating,

(2) investing, and

(3) financing.

ABC Company had no investing activities in January, Year 1.

Prepare Statement of Cash Flows

Statement of Cash Flows ABC Company Statement of Cash Flows For the period January 1-31, Year 1

Operating Activities Cash collected from customers $ 7,500 Cash paid to suppliers (8,000) Net cash flow from operating activities (500)Investing Activities Purchases of long-term assets 0 Net cash flow from operating activities 0Financing Activities Increase in paid-in capital 10,000 Increase in long-term debt (note payable) 5,000 Net cash flow from financing activities 15,000 Net change in cash during the period 14,500Cash balance, January 1 0Cash balance, January 31 $14,500

COMPREHENSIVE EXERCISE

The following transactions occurred during the first month of operations (January, Year 1) for XYZ Company:

1. Company was formed on January 1 by owners contributing $50,000 in exchange for common stock.

2. On January 1, company borrowed $20,000 from bank for 5 years at 12% annual interest rate. Interest payments are made every six months. $20,000 principal will be repaid in 5 years.

3. On January 1, paid $1,000 in rent for 1 month for retail space in a local shopping mall.

4. On January 1, purchased $40,000 of inventory on account.5. On January 1, paid $1,800 for a one-year insurance policy on inventory.6. Sold inventory costing $25,000 for $36,000; one-third for cash, two-thirds on

account.7. Paid supplier for one-half of the inventory purchased in transaction 4.8. Paid salesperson $500 in wages.9. Received a bill from the utility company in the amount of $350; bill had not yet

been paid as of January 31, Year 1.

COMPREHENSIVE EXERCISE (cont)

Required:

A. Use T accounts to:

1. Account for transactions 1–9,

2. record any adjusting entries necessary at the end of the month, and

3. determine the balance in each account at the end of the month. Create different T accounts for each of the different types of expense,

e.g., rent expense, wage expense, utilities expense, insurance expense, interest expense, and cost of goods sold.

B. Prepare a pre-closing trial balance.

C. Prepare the Income Statement and Statement of Retained Earnings from the balances in the pre-closing trial balance.

D. Close the revenue and expense accounts and prepare a post-closing trial balance.

E. Prepare the Balance Sheet from the post-closing trial balance.