BA 284T

FINANCIAL ACCOUNTING
Topic 4 – Basic Procedures
Professor Urooj Khan
Course Roadmap
Day/Date Topic # Topic Title Assignment's Due
Tu/W Aug 20/21 1 Introduction
Th/F Aug 22/23 2 Balance Sheet
M/Tu Aug 26/27 3 Income Statement HW #1
W/Th Aug 28/29 4 Basic Procedures
Tu/W Sep 3/4 5 Cash Flow Statement
Th/F Sep 5/6 6 Revenue Recognition
F Sep 6 HW #2 and
Select your FSA
Project Company
M/Tu Sep 9/10 7 Current Assets – Accounts Receivables
W/Th Sep 11/12 8 Current Assets – Inventory
M/Tu Sep 16/17 9 Long-term Operating Assets HW #3
W/Th Sep 18/19 10 Liabilities – Bonds and Leases
M/Tu Sep 23/24 10/11 Liabilities – Bonds and Leases/Intercorporate
Investments
W/Th Sep 25/26 11/12 Intercorporate Investments/Financial Statement HW #4
Analysis
M/Tu Sep 30/Oct 1 12 Financial Statement Analysis
W/Th Oct 2/3 Final Exam Review HW #5
F Oct 11 FINAL EXAM
Covering material from Topics 1-12
Su Oct 13 FSA Project Due no later than
midnight, Oct 13
Agenda
• We now know
– Institutional background
– The Balance Sheet and the Income Statement

• This topic
– Accounting cycle
– Recording of transactions
– Constructing financial statements

• Next topic
– The Cash Flow Statement
What is Accounting?
• Language of Business
– Identify, measure, record, and communicate economic events in
value terms.
– Provide information for decision-making purposes.
Accounting Cycle
• During the accounting period for each transaction:
1. Collecting source documents
2. Recording journal entry into accounts
3. Posting to the ledger (T-account)

• At the end of the accounting period:

1. Preparing the unadjusted trial balance
2. Recording adjusting entries
3. Preparing the adjusted trial balance
4. Recording and posting closing entries, preparing the financial statements,
and preparing the post-closing trial balance
Transactions
• Any event that impacts the financial position of a business and can be
measured reliably

• Two sides:
– Business gives something
– Business receives something

• Accounting records both sides of a transaction

– Double-entry bookkeeping
An Account
• Record of all changes in a particular asset, liability, equity, revenue, expense,
gain, or loss

• Examples:
– Cash
– Accounts receivables (A/R)
– Accounts payables (A/P)
– Loan
– Sales
– COGS
– Gain/loss on sale of an asset
The Accounting Equation and Double-Entry System
• The accounting equation:
Assets = Liabilities + Shareholders’ Equity

• The accounting equation represents the most aggregated method of

accounting

• Double-Entry System:
– The method usually followed for recording transactions whereby each
transaction affects at least two accounts
– Disaggregates the effects of transactions; it enables us to generate
financial statements and it establishes the foundations for bookkeeping
mechanics
The Accounting Equation – Expanded Form
• Expanded form of the accounting equation

Assets = Liabilities + Stockholders’ equity

Stockholders’ equity = Contributed capital + Retained earnings

Retained earningsEB= Retained earningsBB + Net income - Dividends

Net income = Revenues - Expenses + Gains – Losses + Income (other)

Articulation of the Financial Statements
History and Testimonial
• System believed to be invented in Italy in 1300s
– Luca Pacioli, author of first book written on double-entry accounting
system in 1494 (Summa de Arithmetica)

• Goethe: “among the finest inventions of the human mind” (Wilhelm

Meister’s Apprenticeship)
Analyzing Transactions
• Accounts and effects
– Identify the accounts affected and classify them by type of account
– Determine the direction of the effect (increase or decrease) on each
account

• Balancing
– Verify that the accounting equation (A = L + SE) remains in balance
Analyzing Transactions - Example
• Let’s analyze some transactions for Papa John’s…
– All amounts we use are expressed in thousands of dollars
Analyzing Transactions – Example (a)
• Papa John’s issues $2,000 of additional common stock to new investors
for cash

Account Type (Asset, Liability, Equity) Sign

Cash Asset +
Contributed capital Equity +
Analyzing Transactions – Example (a)
• Papa John’s issues $2,000 of additional common stock to new investors
for cash

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000

Effect 2,000 = 2,000

Analyzing Transactions – Example (b)
• Papa John’s borrows $6,000 from the local bank, signing a three-year
note

Account Type (Asset, Liability, Equity) Sign

Cash Asset +
Note payable Liability +
Analyzing Transactions – Example (b)
• Papa John’s borrows $6,000 from the local bank, signing a three-year
note

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000

Effect 8,000 = 8,000

Analyzing Transactions – Example (c)
• Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash
and signing a two-year note payable for the rest

Account Type (Asset, Liability, Equity) Sign

Equipment Asset +
Cash Asset -
Notes payable Liability +
Analyzing Transactions – Example (c)
• Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash
and signing a two-year note payable for the rest

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000

Effect 16,000 = 16,000

Analyzing Transactions – Example (d)
• Papa John’s lends $3,000 to new franchisees who sign 5-year notes
agreeing to repay the loan

Account Type (Asset, Liability, Equity) Sign

Cash Asset -
Notes receivable Asset +
Analyzing Transactions – Example (d)
• Papa John’s lends $3,000 to new franchisees who sign 5-year notes
agreeing to repay the loan

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000

Effect 16,000 = 16,000

Analyzing Transactions – Example (e)
• Papa John’s purchases $1,000 of stock in other companies as an
investment

Account Type (Asset, Liability, Equity) Sign

Cash Asset -
Investments Asset +
Analyzing Transactions – Example (e)
• Papa John’s purchases $1,000 of stock in other companies as an
investment

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000
(e) (1,000) 1,000

Effect 16,000 = 16,000

Analyzing Transactions – Example (f)
• Papa John’s board of directors declares and pays $3,000 in dividends to
shareholders

Account Type (Asset, Liability, Equity) Sign

Cash Asset -
Retained earnings Equity -
Analyzing Transactions – Example (f)
• Papa John’s board of directors declares and pays $3,000 in dividends to
shareholders

Assets Liabilities Equity

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000
(e) (1,000) 1,000
(f) (3,000) (3,000)
Effect 13,000 = 13,000
T-Accounts
• A T-account is a tool used to represent an account

Account Name

Left Right
Debits and Credits
• A T-account is a tool used to represent an account
– The left side of the T-account is always the debit side
– The right side of the T-account is always the credit side

Account Name

Debit Credit
The Debit-Credit Framework
• Assets increase (decrease) on the debit (credit) side
• Liabilities and equity decrease (increase) on the debit (credit) side

Assets Liabilities Equity

+ - - + - +
Debit for Credit for Debit for Credit for Debit for Credit for
increase decrease decrease increase decrease increase
The Debit-Credit Framework (cont’d)
• Remember: equity includes contributed capital and retained earnings
– Retained earnings increases with net income
– Net income = Revenues - Expenses
Retained
earnings
- +
Debit for
Credit for
decrease
increase
(dividends,
(revenues,
expenses,
gains)
losses)

Revenues Expenses

- + + -
Debit for Credit for Debit for Credit for
decrease increase increases decreases
Different Types of Accounts
• Asset accounts – have left-hand-side (debit) balances; they are increased by entries on the
left-side (debit) and decreased by entries on the right-side (credit)

• Liabilities and Shareholders’ equity accounts – have right-hand-side (credit) balances; they
are increased by entries on the right-side (credit) and decreased by entries on the left-side
(debit).

Asset Cash (Example) Liability/Equity

Beginning 50 Beginning
balance balance

Increases Decreases 10 5 Decreases Increases

Ending Ending
55 balance
balance

where: Ending balance = Beginning balance + Increases - Decreases

Different Types of Accounts (cont’d)
• Revenue and expense accounts
– Part of shareholders’ equity
– Can be summarized as one number – net income (loss) – that
increases (decreases) retained earnings
– Revenues and gains increase shareholders’ equity; thus, they are
carried as right-hand-side (credit) balances
– Expenses and losses decrease stockholders’ equity so they are carried
as left-hand-side (debit) balances
– Flow (instead of stock accounts): no beginning balance
The Journal
• Chronological record of transactions
1. Identify accounts impacted by transaction
2. Apply debit/credit rules for the increase or decrease in the accounts
– You should have at least one debit and one credit
3. Record transactions in journal
Example: Recording Steps
• A. Transactions
– (i) Purchase of merchandise, worth $50, on credit
– (ii) Later on, $20 is paid in cash

• B. Documents
– Invoice for the purchase: $50 (Warehouse)
– Inventory Arrival Note: $50
– Receipt for cash payment: $20
Example: Recording Steps (cont’d)
• C. Journal entries:
(i) dr. Inventory 50
cr. Accounts payable 50

JOURNAL
Date Accounts Debit Credit
XXX Inventory $50
Accounts payable $50
Payment to supplier
Example: Recording Steps (cont’d)
• C. Journal entries:
(ii) dr. Accounts payable 20
cr. Cash 20

JOURNAL
Date Accounts Debit Credit
XXX Accounts payable $20
Cash $20
Purchase inventory on credit
Example: Recording Steps (cont’d)
• D. Posting (T-accounts)

Inventory (A) Cash (A) Accounts payable (L)

(i) Purchase 50 (ii) Payment 20 (ii) Payment 20 (i) Purchase 50
Examples of Effects of Accounting Transactions
dr. A; cr. L buy inventory on credit terms
dr. A; cr. SE obtain new equity financing
dr. A; cr. A purchase equipment for cash
dr. L; cr. A pay back a loan
dr. SE; cr. A declare and pay a dividend
dr. L; cr. L borrow $ to pay trade payables
dr. A; cr. SE record a sale on credit
dr. SE; cr. A to record cost of merchandise sold
Stock Issuance
• Issue common stock for $300 in cash

JOURNAL
Date Accounts Debit Credit
XXX Cash $300
Common stock $300
Stock issuance
Inventory Purchase
• Purchase iPods for $2,000 on credit

Date Accounts Debit Credit

XXX iPod inventory $2,000
A/P $2,000
Purchase iPods
Inventory Sale
• Sell iPods that cost $600 for $700 on credit
Inventory Sale (cont’d)
• Sell iPods that cost $600 for $700 on credit

Date Accounts Debit Credit

XXX A/R $700
Sales $700
iPod Sale

Date Accounts Debit Credit

XXX Cost of Goods Sold $600
iPod Inventory $600
iPod Sale
Cash Dividends
• Pay $50 cash for dividends

• Note:
– All transactions between the company and its shareholders are considered
financing transactions (e.g., payment of dividends, the issuance of stock,
and any subsequent stock repurchase)
– Financing transactions affect only the balance sheet; they do not affect
the income statement
Cash Dividends (cont’d)
• Pay $50 cash for dividends

Date Accounts Debit Credit

XXX Dividends $50
Cash $50
Dividend
Adjusting Entries
Prepaid Expenses (Assets)
• Assume that Apple pays $200 to purchase time on MTV for future iPod
ads

Date Accounts Debit Credit

XXX Pre-paid Advertising $200
Cash $200
Prepaid expenses
Unearned Revenues (Liabilities)
• Assume that Apple receives $400 cash from a customer as advance
payment on a multi-unit iPod sale to be delivered next month

Date Accounts Debit Credit

XXX Cash $400
Unearned Revenue $400
Recording unearned revenue
Recognition of Unearned Revenue as Earned Revenue
• Assume that Apple delivers the iPods a month later (but still within the
fiscal quarter)
– The cost of the iPods is $150
Recognition of Unearned Revenue as Earned Revenue (cont’d)
• Assume that Apple delivers the iPods a month later (but still within the fiscal quarter)
– The cost of the iPods is $150

Date Accounts Debit Credit

XXX Unearned Revenue $400
Sales $400
iPod Sale

Date Accounts Debit Credit

XXX Cost of Good Sold $150
iPod inventory $150
iPod Sale
Accrued Expenses
• Assume that Apple’s sales staff earns $100 of sales commissions this
period that will not be paid until next period

Date Accounts Debit Credit

XXX Wages expense $100
Wages Payable $100
Accrued wage expense
Accrued Expenses (Liabilities)
• Assume Apple incurred $25 of rent which is yet to be paid

Date Accounts Debit Credit

XXX Rent Expense $25
Accrued Rent $25
Incurred rent yet to be paid
Accrued Revenues (Assets)
• Assume that Apple delivers iPods to a customer in Germany who will pay
next quarter
– The sales price for those units is $500 and the cost is $400
Accrued Revenues (Assets) (cont’d)
• Assume that Apple delivers iPods to a customer in Germany who will pay next quarter
– The sales price for those units is $500 and the cost is $400

Date Accounts Debit Credit

XXX Accounts Receivables $500
Sales $500
iPod Sale

Date Accounts Debit Credit

XXX Cost of Good Sold $400
iPod inventory $400
iPod Sale
Apple’s Transactions thus far…
Unadjusted
Trial Balance
(not 100% Accrual
Basis)

Adjusting
Entries

Adjusted
Trial Balance
(100% Accrual
Basis)

Create
Financial
Statements

I/S B/S SCF SE

Trial Balance
• The trial balance is a listing of all accounts and their balances at a point
in time
– Its purpose is to prove the mathematical equality of debits and
credits, provide a useful tool to uncover any accounting errors, and
help prepare the financial statements
Adjusted Trial Balance
Preparation of Financial Statements
• Income Statement
Preparation of Financial Statements
• Retained Earnings Computation
Preparation of Financial Statements
• Statement of Shareholder’s (or Stockholder’s) Equity
Preparation of Financial Statements
• Balance Sheet
Closing Process
• The closing process refers to the ‘zeroing out’ of revenue and expense
accounts (the temporary accounts) by transferring their ending balances to
retained earnings
• Balance sheet accounts carry over from period to period and are called
permanent accounts
• The result is that all income statement accounts begin the next period with
zero balances
Closing Process – Journal Entries
Takeaways
• The accounting cycle has many steps

• Understand the recording of transactions using the accounting equations

and/or journal entries

• Prepare T-accounts and the financial statements

Next Class
• Topic #5 – Cash Flow Statement