Chapter 2 Review of the Accounting Process

Chapter 2 Review of the Accounting Process

Teaching Transparency Masters

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TRANSACTION ANALYSIS

Ø Each transaction is analyzed to determine its effect on the equation and on the specific financial position elements.

1. An attorney invested $50,000 to open a law office.

An investment by the owner causes both assets and owners’ equity to increase.

Assets = Liabilities + Owners’ Equity

+ $50,000 (cash) + $50,000 (investment by owner)

2. $40,000 was borrowed from a bank and a note payable was signed.

This transaction causes assets and liabilities to increase. A bank loan increases cash and creates an obligation to repay it.

Assets = Liabilities + Owners’ Equity

+ $40,000 (cash) + $40,000 (note payable)

3. Supplies costing $3,000 were purchased on account.

Buying supplies on credit also increases both assets and liabilities.

Assets = Liabilities + Owners’ Equity

+ $3,000 (supplies) + $3,000 (accounts payable)

Illustration 2-1

T2-1

TRANSACTION ANALYSIS(continued)

4. Services were performed on account for $10,000.

Transactions 4, 5, and 6 are revenue and expense transactions. Revenues and expenses (and gains and losses) are events that cause owners’ equity to change. Revenues and gains describe inflows of assets, causing owners’ equity to increase. Expenses and losses describe outflows of assets (or increases in liabilities), causing owners’ equity to decrease.

Assets = Liabilities + Owners’ Equity

+ $10,000 (receivables) + $10,000 (revenue)

5. Salaries of $5,000 were paid to employees.

Assets = Liabilities + Owners’ Equity

- $5,000 (cash) - $5,000 (expense)

6. $500 of supplies were used.

Assets = Liabilities + Owners’ Equity

- $500 (supplies) - $500 (expense)

7. $1,000 was paid on account to the supplies vendor.

This transaction causes assets and liabilities to decrease.

Assets = Liabilities + Owners’ Equity

- $1,000 (cash) - $1,000 (accounts payable)

Illustration 2-1 (continued)

T2-1 (continued)

ACCOUNTING EQUATION FOR A CORPORATION

Ø Owners' equity for a corporation, called shareholders' equity, is classified as either paid-in capital or retained earnings.

Graphic 2-1

T2-2

ACCOUNTING EQUATION

DEBITS AND CREDITS

INCREASES AND DECREASES

Assets = Liabilities + Common Shares + Retained Earnings

______

Debit Credit Debit Credit Debit Credit Debit Credit

+ - - + - + - +

é

¾¾¾¾¾¾

Revenues and Gains Exp.& Losses

Debit Credit Dr Cr.

- + + -

Graphic 2–2

T2-3

JOURNAL ENTRIES

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, 2004, and July 1, 2005.

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.

Illustration 2-3

T2-4

GENERAL JOURNAL

Illustration 2-4

T2-4 (continued)

GENERAL LEDGER

Cash 100 Prepaid Rent 130

GJ 1 60,000 24,000 GJ 1 GJ 1 24,000

GJ 1 40,000

Note Payable 220 Common Stock 300

40,000 GJ 1 60,000 GJ 1

T2-5

UNADJUSTED TRIAL BALANCE

Illustration 2-6

T2-6

ADJUSTING ENTRIES

 Even when all external transactions and events are analyzed, journalized, and posted correctly to the appropriate ledger accounts, some account balances will require updating.

Graphic 2-3

T2-7

PREPAYMENTS

 Prepayments occur when the cash flow precedes either expense or revenue recognition.

Ø prepaid expenses

Prepaid expenses represent assets recorded when a cash disbursement creates a benefit beyond the current reporting period.

To record the cost of supplies used during the month of July.

July 31

Supplies expense 800

Supplies 800

Supplies Supplies expense

2,000

800  800

______

Balance 1,200

T2-8

PREPAYMENTS(continued)

To record the cost of expired rent for the month of July.

July 31

Rent expense ($24,000 ÷ 12) 2,000

Prepaid rent 2,000

To record amortization of furniture and fixtures for the month of July.

July 31

Amortization expense 200

Accumulated amortization -

furniture and fixtures 200

Ø unearned revenues

Unearned revenues represent liabilities recorded when cash is received from customers in advance of providing a good or service.

To record the amount of unearned rent revenue earned during July.

July 31

Unearned rent revenue 250

Rent revenue 250

T2-8 (continued)

ACCRUALS

 Accruals involve transactions where the cash outflow or inflow occurs in a period subsequent to expense or revenue recognition.

Ø accrued liabilities

Accrued liabilities represent liabilities recorded when an expense has been incurred prior to cash payment.

To record accrued salaries at the end of July.

July 31

Salaries expense 5,500

Salaries payable 5,500

To accrue interest expense for July on notes payable.

$40,000 x 10% x 1/12 = $333 (rounded)

July 31

Interest expense 333

Interest payable 333

T2-9

Ø accrued receivables

Accrued receivables involve situations when the revenue is earned in a period prior to the cash receipt. Assume that Dress Right loaned another corporation $30,000 at the beginning of August evidenced by a note receivable. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months.

To accrue interest revenue earned in August on notes receivable.

August 31

Interest receivable 200

Interest revenue ($30,000 x 8% x 1/12) 200

T2-9 (continued)

ESTIMATES

 Estimates often are made to comply with the accrual accounting model. One estimate that does not fit neatly into either the prepayment or accrual classification is bad debt expense.

To record bad debt expense for July.

July 31

Bad debt expense 500

Allowance for uncollectible accounts 500

T2-10

ADJUSTED TRIAL BALANCE

Illustration 2-8

T2-11

THE INCOME STATEMENT

DRESS RIGHT CLOTHING CORPORATION

Income Statement

For the Month of July 2003

Sales revenue $38,500

Cost of goods sold 22,000

Gross profit 16,500

Operating expenses:

Salaries expense $10,500

Supplies expense 800

Rent expense 2,000

Amortization expense 200

Interest expense 333

Bad debt expense 500

Total operating expenses 14,000

Operating income 2,500

Other income (expense):

Rent revenue 250

Interest expense (333) (83)

Net income $2,417

Illustration 2-9

T2-12

THE BALANCE SHEET

DRESS RIGHT CLOTHING CORPORATION

Balance Sheet

At July 31, 2003

Assets

Current assets:

Cash $ 68,500

Accounts receivable $ 2,000

Less: Allowance for uncollectible accounts (500) 1,500

Supplies 1,200

Inventory 38,000

Prepaid rent 22,000

Total current assets 132,200

Property and equipment:

Furniture and fixtures 12,000

Less: Accumulated amortization (200) 11,800

Total assets $143,000

Liabilities and Shareholders’ Equity

Current liabilities:
Accounts payable $ 35,000
Salaries payable 5,500
Unearned rent revenue 750
Interest payable 333
Note payable 10,000
Total current liabilities 51,583
Long-term liabilities:

Note payable 30,000

Shareholders’ equity:
Common stock, 6,000 shares issued and outstanding $60,000
Retained earnings 1,417 *
Total shareholders’ equity 61,417
Total liabilities and shareholders’ equity $143,000

* Beginning retained earnings + net income - dividends

0 + $2,417 - $1,000 = $2,417

Illustration 2-10

T2-13

THE STATEMENT OF CASH FLOWS

DRESS RIGHT CLOTHING CORPORATION

Statement of Cash Flows

For the Month of July 2003

Cash Flows from Operating Activities:

Cash inflows:

From customers $ 36,500

From rent 1,000

Cash outflows:

For rent (24,000)

For supplies (2,000)

To suppliers of merchandise (25,000)

To employees (5,000)

Net cash used by operating activities $(18,500)

Cash Flows from Investing Activities:

Purchase of furniture and fixtures (12,000)

Cash Flows from Financing Activities:

Issue of common stock $ 60,000

Increase in notes payable 40,000

Payment of cash dividend (1,000)

Net cash provided by financing activities 99,000

Net increase in cash $68,500

Illustration 2-11

T2-14

THE STATEMENT OF SHAREHOLDERS' EQUITY

DRESS RIGHT CLOTHING CORPORATION

Statement of Shareholders' Equity

For the Month of July 2003

Total

Common Retained Shareholders’

Stock Earnings Equity

Balance at July 1, 2003 - 0 - - 0 - - 0 -

Issue of common stock $ 60,000 $ 60,000

Net income for July 2003 $ 2,417 2,417

Less: Dividends ______(1,000) (1,000)

Balance at July 31, 2003 $ 60,000 $ 1,417 $ 61,417

Illustration 2-12

T2-15

THE CLOSING PROCESS

To close the revenue accounts to income summary

Sales revenue 38,500

Rent revenue 250

Income summary 38,750

To close the expense accounts to income summary

Income summary 36,333

Cost of goods sold 22,000

Salaries expense 10,500

Supplies expense 800

Rent expense 2,000

Amortization expense 200

Interest expense 333

Bad debt expense 500

Income Summary

Expenses Revenues

______

Net income

To close income summary to retained earnings

Income summary 2,417

Retained earnings 2,417

After this entry is posted to the accounts, the temporary accounts have zero balances and retained earnings has increased by net income.

T2-16

POST-CLOSING TRIAL BALANCE

Illustration 2-13