Chapter 2 PDF

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Summary

Chapter 2 of financial accounting...

Description

CHAPTER 2 REVIEW OF THE ACCOUNTING PROCESS Economic events cause changes in the financial position of a company. 

External events involve an exchange between the company and another entity.



Internal events do not involve an exchange transaction but do affect the company’s financial position.

The Basic Model – Accounting Equation:

A = L + OE + Owner Investments - Owner Withdrawals

+ Revenue + Gains

- Expenses - Losses



Each transaction has a dual effect on the accounting equation (duality of effects).



The double-entry system is used to process transactions (debit-credit framework).  Elements of the accounting equation are represented by accounts in a general ledger.  In the double-entry system, debit means left side of an account, and credit means right side of an account.

A = L + OI + RE + R + G- E - L - D

Increases Decreases Normal Balance

Assets

Liabilities

Dr Cr Dr

Cr Dr Cr

Owners’ Equity Cr Dr Cr

1

Revenue/ Gains Cr Dr Cr

Expense/ Losses Dr Cr Dr

Dividend Dr Cr Dr

Rules of Debit and Credit Assets

=

Liabilities

+

Stockholders’ Equity

Dr

Cr

Dr

Cr

Dr

Cr

+

-

-

+

-

+

Contributed Capital

Revenue, Expense (Gain, Loss)and Dividend are called Temporary or Nominal accounts.

All accounts on the balance sheet are considered Real or Permanent accounts

+ Retained Earnings

Dr

Cr

Dr

Cr

-

+

-

+

Revenues

-

Expenses

-

Dividends

Dr

Cr

Dr

Cr

Dr

Cr

-

+

+

-

+

-

Example: Beverly Woods is a licensed CPA. During the first month of operations of her business, the following events and transactions occurred. August 2

Invested $20,000 cash and equipment valued at $12,000 in the business.

August 3

Purchased supplies on account $700. (Debit an asset account.)

August 11

Completed a tax assignment and billed client $3,100 for services rendered. (Use Service Revenue account.)

August 21

Borrowed $50,000 from GS Bank and signed a note payable.

2

August 30

$350 was paid on account to supplies vendor.

Accounting Cycle

Start

Prepare post-closing trial balance

Analyze transactions

Close Journalize Post

Prepare statements

Prepare unadjusted trial balance

Prepare adjusted trial balance

Adjust

On July 1, 2020, the owners invest $60,000 in a new business, Dress Right Clothing Corporation. 1) Analyze the transaction

2) Record the transaction in a journal Journal – a book that provides a chronological record of all economic events affecting a firm. We will be making entries, as they would appear in a General Journal. Special journals are used to record a repetitive type of transactions such as sales, purchase, cash disbursement, cash receipts, etc. Journal entries – an accounting method for expressing the effects of a transaction on accounts in a debits-equal-credits format.

3

GENERAL JOURNAL Date

Page Post. Ref.

Description

July 1 Cash

Debit

1 Credit

60,000 Common Stock

60,000

3 3) Post from the journal to the general ledger: Account – a standardized format used by companies to accumulate the dollar effects of transactions on each financial statement item. Ledger – a book that maintains all accounts. GENERAL LEDGER Account:

Acct. No.

## Balance

Date

Item

Post. Ref.

Debit

Credit

DR (CR)

GENERAL LEDGER Acct. No.

Account: Cash

Date July 1

I tem

Post. Ref. J1

Debit 60,000

Credit

100

Balance 60,000

GENERAL LEDGER Acct. No.

Account: Common Stock

Date July 1

Item

Post. Ref. J1

Debit

4

Credit 60,000

300

Balance 60,000

Example of Accounting Process: July 1

Two individuals each invested $30,000 in the corporation. Each investor was issued 3,000 shares of common stock.

July 1

Borrowed $40,000 from a local bank and signed two notes. The first note for $10,000 requires payment of principal and 10% interest in six months. The second note for $30,000 requires the payment of principal in two years. Interest at 10% is payable each year on July 1, 2021, and July 1, 2022.

July 1

Paid $24,000 in advance for one year’s rent on the store building.

July 1

Purchased furniture and fixtures from Acme Furniture for $12,000 cash.

July 3

Purchased $60,000 of clothing inventory on account from the Birdwell Wholesale Clothing Company.

July 6

Purchased $2,000 of supplies for cash.

July 4-31

Sold merchandise costing $20,000 for $35,000 cash.

July 9

Sold clothing on account to St. Jude’s School for Girls for $3,500. The clothing cost $2,000.

July 16

Subleased a portion of the building to a jewelry store. Received $1,000 in advance for the first two months’ rent beginning on July 16.

July 20

Paid Birdwell Wholesale Clothing $25,000 on account.

July 20

Paid salaries to employees for the first half of the month, $5,000.

July 25

Received $1,500 on account from St. Jude’s.

July 30

The corporation paid its shareholders a cash dividend of $1,000.

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PAGE 1

GENERAL JOURNAL Date

Account Title and Explanation

Post Ref.

Debit

2020 7/1

Cash

100 300

60,000

100 220

40,000

Prepaid Rent Cash To record the payment of one year’s rent in advance.

130 100

24,000

Furniture & Fixtures Cash To record the purchase of furniture and fixtures.

150 100

12,000

Inventory Account Payable To record the purchase of merchandise inventory.

140 210

60,000

Supplies Cash To record the purchase of supplies.

125 100

2,000

Cash

100 400

35,000

500 140

20,000

Common Stock To record the issuance of common stock. 7/1

Cash Notes Payable To record the borrowing of cash and the signing of notes payable.

7/1

7/1

7/3

7/6

7/4-31

Sales Revenue To record cash sales for the month. 7/4-31

Cost of Goods Sold Inventory

6

Credit

60,000

40,000

24,000

12,000

60,000

2,000

35,000

20,000

To record the cost of cash sales. 7/9

7/9

7/16

Account Receivable Sales Revenue To record credit sale.

110 400

3,500

Cost of Goods Sold Inventory To record the cost of a credit sale.

500 140

2,000

Cash

100 230

1,000

Account Payable Cash To record the payment of accounts payable.

210 100

25,000

Salaries Expense Cash To record the payment of salaries for the first half of the month.

510 100

5,000

Cash

100 110

1,500

320 100

1,000

Unearned Revenue To record the receipt of rent in advance. 7/20

7/20

7/25

Account Receivable To record the receipt of cash on account. 7/30

Dividends Cash To record the payment of a cash dividend.

7

3,500

2,000

1,000

25,000

5,000

1,500

1,000

GENERAL LEDGER

Cash

Accounts Receivable 110

100

7/1 J1 60,000 7/1 J1 24,000 7/1 J1 40,000 7/1 J1 12,000 7/6 J1 2,000 7/4-31 J1 35,000 7/20 J1 25,000 7/16 J1 1,000 7/20 J1 5,000 7/25 J1 1,500 7/30 J1 1,000 7/31 68,500 Supplies

7/9 J1 3,500 7/25 J1 1,500 7/31 2,000

125

Prepaid Rent 130

7/6 J1 2,000 7/31 2,000

Inventory

7/1 J1 24,00 7/31 24,000

Furniture and and Fixture 150

140

7/3 J1 60,000 7/4-31 J1 20,000 7/9 J1 2,000 7/31 38,000

7/1 J1 12,000 7/31

Accumulated Depreciation 155

12,000

Allowance for Uncollectible Accounts 115

8

Accounts Payable 210

Note Payable

7/20 J1 25,000 7/3 J1 60,000 7/31 35,000

7/1 J1 40,000 7/31 40,000

Unearned Rent Revenue 230

Interest Payable

240

7/16 J1 1,000 7/31 1,000

Retained Earnings 310

Common Stock 300 7/1 J1 60,000 7/31 60,000

Dividends 320 7/31 7/31

220

1,000 1,000

9

Sales Revenue 410

Rent Revenue 410

7/4-31 J1 35,000 7/9 J1 3,500

Cost of Goods Sold 500

Salaries Expense

7/4-31 J1 20,000 7/9 J1 2,000 7/31 22,000

Supplies expense

510

7/20 J1 5,000 7/31 5,000

520

Rent Expense

Depreciation Expense 540

530

Interest Expense 550

Bad Debt Expense 560

Income Summary 600

10

4) Prepare an unadjusted trial balance: Trail balance – a simple list of each account with its dollar balance on some specific date.

DRESS RIGHT CLOTHING CORPORATION

Unadjusted Trial Balance July 31, 2020 Account Title

Debits

Cash Accounts receivable Supplies Prepaid rent Inventory Furniture and fixtures Accounts payable Note payable Unearned rent revenue Common stock Retained earnings Dividends Sales revenue Cost of goods sold Salaries expense Totals

68,500 2,000 2,000 24,000 38,000 12,000

Credits

35,000 40,000 1,000 60,000 0 1,000 38,500 22,000 5,000 174,500

11

____ 174,500

5) Record adjusting entries and post to the ledger accounts: Adjusting Journal Entries (AJEs) – journal entries recorded at the end of the accounting period to update the accounts for proper revenue recognition and expense matching, and to properly reflect the assets and liabilities. Deferrals - Transactions where cash is paid or received before a related expense or revenue is recognized. Example: On May 1, 2020, Spartan Apartments received $4,800 from a new tenant for one year’s rent in advance (starting the same day). What is the adjusting entry on September 30, 2020 (the fiscal year end)?

Example: On May 1, 2020, you paid $4,800 for one year’s rent in advance (starting the same day). What is the adjusting entry on December 31, 2020 (the fiscal year end)?

Accruals - Transactions where cash is paid or received after a related expense or revenue is recognized. Example: On July 1, 2020, Jane’s Craft Shop lent $10,000 to one of its customers and received a one-year note with 10% interest rate. What is the adjusting entry necessary on December 31, 2020, the end of the company’s fiscal year?

Example: A company pays its employees every Friday. The accounting period ended on December 31, 2020, a Wednesday. If the weekly payroll is $1,500 for five days of work, what was the adjusting entry on December 31, 2020?

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Adjusting Entries Expenses Debit Credit Expense Asset Expense Liability

Deferrals Accruals

Revenues Debit Credit Liability Revenue Asset Revenue

Estimates: Accountants often make estimates (such as bad debt, depreciation, etc.) to comply with the accrual accounting model.

Continue on Dress Right example… Assume that on July 31, 2020, Dress Right determines that at the end of July $1,200 of supplies remains.

July 31 Supplies expense..................................................... Supplies ..............................................................

800 800

Recall that at the beginning of July, Dress Right paid $24,000 to its landlord for one year’s rent.

July 31 Rent expense ........................................................... Prepaid rent ........................................................

2,000 2,000

Assume that the furniture and fixtures have a useful life of five years and zero salvage value. Dress Right allocated cost equally over the period of use (straight-line depreciation). Depreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives.

Straight-Line Depreciation Expense

Asset Cost - Salvage Value = Useful Life

Depreciation expense .............................................. Accumulated depreciation furniture and fixtures......................................

13

200 200

Recalled that Dress Right received $1,000 in advance for the first two months’ rent beginning on July 16. July 31 Unearned rent revenue ............................................ Rent revenue ......................................................

250 250

On July 31, 2020, the employees have earned salaries of $5,500. July 31 Salaries expense...................................................... Salaries payable .................................................

5,500 5,500

Recall that Dress Right borrowed $40,000 from a local bank and signed two notes on July 1, 2020. The first note for $10,000 requires payment of principal and 10% interest in six months. The second note for $30,000 requires the payment of principal in two years. Interest at 10% is payable each year on July 1, 2021, and July 1, 2022. July 31 Interest expense ...................................................... Interest payable ..................................................

333 333

Assume that Dress Right loaned another corporation $30,000 at the beginning of August. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. August 31 Interest receivable .............................................................. Interest revenue .............................................................

200 200

Assume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, 2020, only $1,500 will ultimately be collected.

July 31 Bad debt expense ................................................................... Allowance for uncollectible accounts ...............................

14

500 500

6) Prepare an adjusted trial balance: DRESS RIGHT CLOTHING CORPORATION

Adjusted Trial Balance July 31, 2020 Account Title Cash Accounts receivable Allowance for uncollectible accounts Supplies Prepaid rent Inventory Furniture and fixtures Accumulated depreciation furniture and fixtures Accounts payable Notes payable Unearned rent revenue Salaries payable Interest payable Common stock Retained earnings Dividends Sales revenue Rent revenue Cost of goods sold Salaries expense Supplies expense Rent expense Depreciation expense Interest expense Bad debt expense Totals

Debits 68,500 2,000

Credits

500 1,200 22,000 38,000 12,000 200 35,000 40,000 750 5,500 333 60,000 0 1,000 38,500 250 22,000 10,500 800 2,000 200 333 500 181,033

15

_____ 181,033

7) Prepare financial statements:

DRESS RIGHT CLOTHING CORPORATION Income Statement For the Month of July 2020 Sales revenue Cost of goods sold Gross profit Operating expenses: Salaries Supplies Rent Depreciation Bad debt Total operating expenses Operating income Other income (expense): Rent revenue Interest expense Net income

$38,500 22,000 16,500 $10,500 800 2,000 200 500 14,000 2,500 250 (333)

16

(83) $2,417

DRESS RIGHT CLOTHING CORPORATION Balance Sheet At July 31, 2020 Assets Current assets: Cash Accounts receivable Less: Allowance for uncollectible accounts Supplies Inventory Prepaid rent Total current assets Property and equipment: Furniture and fixtures Less: Accumulated depreciation Total assets

$ 68,500 $ 2,000 (500)

12,000 (200)

Liabilities and Shareholders’ Equity Current liabilities: Accounts payable Salaries payable Unearned rent revenue Interest payable Note payable Total current liabilities Long-term liabilities: Note payable Shareholders’ equity: Common stock, 6,000 shares issued and outstanding $60,000 1,417 * Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity * Beginning retained earnings + net income - dividends 0 + $2,417 - $1,000

17

=

$1,417

1,500 1,200 38,000 22,000 132,200

11,800 $143,000

$ 35,000 5,500 750 333 10,000 51,583 30,000

61,417 $143,000

DRESS RIGHT CLOTHING CORPORATION Statement of Cash Flows For the Month of July 2020 Cash Flows from Operating Activities: Cash inflows: From customers From rent Cash outflows: For rent For supplies To suppliers of merchandise To employees Net cash flows from operating activities

$ 36,500 1,000 (24,000) (2,000) (25,000) (5,000) $(18,500)

Cash Flows from Investing Activities: Purchase of furniture and fixtures

(12,000)

Cash Flows from Financing Activities: Issue of common stock Increase in notes payable Payment of cash dividend Net cash flows from financing activities

$ 60,000 40,000 (1,000) 99,000 $68,500

Net increase in cash

DRESS RIGHT CLOTHING CORPORATION Statement of Shareholders’ Equity For the Month of July 2020

Balance at July 1, 2006 Issue of common stock Net income for July 2006 Less: Dividends Balance at July 31, 2006

Common Stock

Retained Earnings

-0$ 60,000

-0-

______ $ 60,000

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$ 2,417 (1,000) $ 1,417

Total Shareholders’ Equity -0$ 60,000 2,417 (1,000) $ 61,417

8) Close the temporary accounts to retained earnings: The purposes of closing entries  Resets revenue, expense and dividend account balances to zero at the end of the period.  Helps summarize a period’s revenues and expenses in the Income Summary account. To close the revenue accounts to income summary Sales revenue ............................................