Financial Accounting

Chapters 2, 3 and 4 Supplementary Notes and Practice

CHAPTER 2

Debit—an entry on the left side of an account

Credit—an entry on the right side of an account

A debit will increase some accounts but decrease other accounts. See the rules of debit and credit below.

Double entry accounting—traditional system using debits and credits to record transactions. For each transaction recorded, the total of the debits recorded should equal the total of the credits recorded. At least two accounts will be affected in recording any one transaction. For many transactions, only two accounts will be affected. In those instances, one account will be debited while the other account will be credited.

Separate entity concept—the business is separate from its owners. Transactions are recorded from the business’ perspective, not the owners.

Transactions involving cash—if cash has been received or paid, cash will be one of the accounts used in recording the transaction. In double entry systems, at least two accounts are used in recording any transaction. The other account affected indicates where the cash went to or came from. A large percentage of the transactions in chapter 2 involve cash. Cash is an asset. Like all other assets, cash will be increased with a debit and decreased with a credit. Many find it easy to handle the cash part of transaction first (say whether it is debited or credited). If cash is debited, the other account affected in recording the transaction will be credited. If cash is credited, the other account affected in recording the transaction will be debited.

Remembering the rules of debit and credit—I prefer that students remember the rules of debit and credit thru practice. At first, students will get use to handling “asset” accounts, because many of the transactions recorded are transactions involving cash. Thru practice, students will become familiar with handling the other accounts (liabilities, capital, withdrawals, revenues and expenses). After we do four or five practice problems, you will start to remember the diagrams for the other accounts.

IMPORTANT RULES OF DEBIT AND CREDIT

Asset

Debit Credit

Increase

Decrease

Balance

Liability

Debit Credit

Increase

Decrease

Balance

Capital

Debit Credit

Increase

Decrease

Balance

Withdrawals

Debit Credit

Increase

Balance

Revenue

Debit Credit

Increase

Balance

Expenses

Debit Credit

Increase

Balance

Natural ending balance—on the increase side

Assets—Resources owned

Cash

Supplies on hand

Accounts receivable

Prepaid insurance

Equipment

Building

Land

Liabilities—Debt

Accounts Payable

________Payable

Unearned Revenue or Revenue Received in Advance

Owners’ Equity

Revenue (starts year with zero balance)

Expenses (starts year with zero balance)

Capital—account initially used by sole proprietor to show when assets have been put into a business

Withdrawals—(starts year with zero balance) account used when sole proprietor owner removes assets from the business

Difference between recording transactions for a sole proprietor and a corporation—In comparing corporations to sole proprietorships, there will be differences in the way transactions are recorded between the business and its owner/s. For a sole proprietor, “withdrawals” and “capital” are used when the sole proprietor removes assets from or contributes assets to the business. For a corporation, owners are stockholders. Stockholder owners may be paid “wages” for work done in the capacity as an employee or “dividends” as a return on the stock investment. Stockholders may contribute money to the corporation as a loan (a liability account would be credited) or as a contribution (specific paid in capital accounts would be credited).

Financial Statements—statements showing ending balances in accounts

Balance sheet—Also known as the statement of financial position, this financial statement shows assets and liabilities at one point in time. Total assets on the statement should equal total liabilities plus owners’ equity on the statement.

Income statement—Financial statement showing revenues and expenses for a period of time. The date portion of the income statement will indicate a “period” of time. On a single step income statement, revenues less expenses will equal net income or net loss.

Statement of Cash Flows—Financial Statement showing cash inflows and outflows by major categories. It is prepared thru an analysis of changes in the accounts. The last topic we deal with in this course is preparation of the statement of cash flows.

Things to remember

Classification of accounts is very important, because each of the accounts are increased and decreased according to the type of account it is (asset, liability, capital, withdrawals, revenues and expenses). See the T account diagrams listed in rules of debit and credit.
All asset accounts will be increased and decreased following the asset diagram. Cash, like all other assets, is increased with a debit and decreased with a credit.
Revenue is earned and recorded when services are rendered or goods are sold.
If one transaction refers to a prior transaction, you must look at the prior transaction in recording this transaction to avoid double recording a revenue or an expense and avoid misstating a receivable or liability account.
The rules of debit and credit are used throughout this course and future accounting courses. Since these rules are used repeatedly throughout the term, it is important that you familiarize yourself with these rules.

Journal entry—entry to record a transaction into the accounting format. Typically debited accounts are listed first. Credited accounts are indented and listed last. Number position overrules though.

Example

Cash 2,000

Revenue 2,000

To record cash collected for services rendered by the business

General journal—place where journal entries are recorded

General ledger—a book of all accounts; it shows details of all postings.

Chart of Accounts—listing of all accounts with numerical reference numbers. People often use the instructions provided with their general ledger software for setting up accounts and assigning account numbers. The instructions will say that assets should be assigned numbers within a certain range. Liability accounts should be assigned numbers within a certain range, etc. Usually spaces are left between account numbers when assigning numbers for later addition of accounts.

Trial Balance—A listing of accounts and current balances in the ending balance position

Problem One Make journal entries to record the following transactions. [Wording revised for a corporate form of business instead of a sole proprietor.]

Mr. Smith, a sole proprietor, contributed $10,000 of his own money to establish the business checking account. [Mr. Smith contributes money to the business in exchange for his stock]
Paid business rent, $400
Paid wages, $600
Bought supplies for cash, $150
Purchased six months of insurance in advance, $600
Collected $5,000 from a customer for services rendered.
Rendered services for another customer and billed that customer $4,000.
Collected $3,000 from the customer in “g”
Signed a note payable with a bank and collected $15,000 cash.
Repaid $2,000 of the amount borrowed in “i” (treat all as principal)
Collected $5,000 from one customer as a deposit before services were performed.
Purchased supplies costing $200 on credit.
Paid for the supplies in “l”
Paid Mr. Smith $2,000 cash for his personal use [Business paid a $2,000 cash dividend to Mr. Smith.]

Problem Two Make journal entries to record the following transactions. [Wording revised for a corporate form of business instead of a sole proprietor.]

Ms. Jones, a sole proprietor, contributed $15,000 of his own money to establish the business checking account. [Ms. Jones contributes $15,000 cash to the business in exchange for his stock]
Paid advertising, $200
Paid utilities, $300
Bought supplies for cash, $200
Purchased seven months of insurance in advance, $700
Collected $4,000 from a customer for services rendered.
Rendered services for another customer and billed that customer $1,000.
Collected $1,000 from the customer in “g”
Signed a note payable with a bank and collected $10,000 cash.
Repaid $4,000 of the amount borrowed in “i” (treat all as principal)
Collected $5,000 from one customer as a deposit before services were performed.
Purchased supplies costing $300 on credit.
Paid $200 for the supplies in “l”
Paid Ms. Jones $1,000 cash for his personal use [Business paid a $1,000 cash dividend to Mr. Smith.]

CHAPTER 3

Calendar year end—December 31 year end

Fiscal year—Any twelve month accounting period.

A business may elect to have a year end different from December 31.

Adjusting journal entries—journal entries that update or correct the accounts. Adjusting entries may be made at any time, but are mandatory for all companies at year end before financial statements are prepared.

Examples of typical situations requiring adjusting entries:

Supplies have been used up
Prepaid insurance has expired
Work is later performed when money was paid in advance
Wages are recorded for the time period since the last pay date thru year end
Depreciation expense is recorded
Interest which accrues with time has not been recorded

Depreciation expense—The cost of a tangible long lived asset should be spread as an expense over the estimated life of the asset. This allocated expense is known as depreciation. Future chapters will deal with different methods of computing the depreciation expense amount. In chapter 3, we will be given the amount to record. We will not be computing the amount.

ADJUSTING JOURNAL ENTRY TO RECORD DEPRECIATION

Depreciation Expense xxxxx

Accumulated Depreciation xxxxxx

To record depreciation expense

Contra account—offsetting account; contra accounts are presented on financial statements and the trial balance immediately after the account being offset

Accumulated depreciation is a contra account offsetting the asset being depreciated. It has a natural credit balance. Each year, depreciation is recorded in the accumulated depreciation account until the asset if fully depreciated.

Problem Three Assume that the business has a December 31^st business year end. Make year end adjusting entries for each of the following.

Before adjustments, supplies on hand has a balance of $1,000. A physical count shows that only $800 is on at hand at year end.
Before adjustments, prepaid insurance has a balance of $800 representing an eight month policy purchased November 1. Since the purchase, there has been no adjustments to the prepaid insurance account.
Revenue received in advance has a balance of $5,000. At year end, it is determined that services had been rendered for $2,000 of the related work.
Wages of $20,000 are paid each Friday for the five day workweek. Employees do not work on Saturdays and Sundays. December 31^st is a Tuesday.
Depreciation on the equipment of $2,000 has not yet been recorded.

Problem Four Assume that the business has a December 31^st business year end. Make year end adjusting entries for each of the following.

Before adjustments, supplies on hand has a balance of $2,400. A physical count shows that only $200 is on at hand at year end.
Before adjustments, prepaid insurance has a balance of $400 representing a four month policy purchased October 1st. Since the purchase, there has been no adjustments to the prepaid insurance account.
Revenue received in advance has a balance of $1,000. At year end, it is determined that services had been rendered for all of the related work.
Wages of $15,000 are paid each Friday for the five day workweek. Employees do not work on Saturdays and Sundays. December 31^st is a Thursday.
Depreciation on the equipment of $1,000 has not yet been recorded.

Problem Five Assume that the business has a December 31^st business year end. Make year end adjusting entries for each of the following.

Before adjustments, supplies on hand has a balance of $700. A physical count shows that only $300 is on at hand at year end.
Before adjustments, prepaid insurance has a balance of $700 representing a seven month policy purchased September 1st. Since the purchase, there has been no adjustments to the prepaid insurance account.
Revenue received in advance has a balance of $4,000. At year end, it is determined that services had been rendered for $1,000 of the related work.
Wages of $15,000 are paid each Friday for the five day workweek. Employees do not work on Saturdays and Sundays. December 31^st is a Monday.
Depreciation on the automobile is $500. It has not yet been recorded.

CHAPTER 4

Closing entries—journal entries made to zero temporary accounts (accounts starting each year with a zero balance). Closing entries are made ONLY at year end after accounts have been adjusted and financial statements prepared.

Income summary—an account created only during the closing process for the purpose of closing revenue and expense accounts. This account is then closed immediately.

Temporary Accounts (or nominal accounts)—accounts starting each year with a zero balance. Revenues, expenses, income summary and withdrawals are temporary accounts.

Permanent Accounts (or real accounts)—accounts not closed at year end. On a trial balance listed in standard sequence, permanent accounts are listed first and temporary accounts are listed last.

Closing process—to close an account, an entry must be made on the opposite of the account’s natural balance side. Revenues would be debited to be closed. Expenses would be credited to be closed. Withdrawals would be credited to be closed. To close income summary, the account should be drawn to see whether a debit or credit would zero this account. If there is net income, a debit will be required to close the account. If there is a net loss, a credit will be required to close the account.

Steps in closing (a journal entry is made for each step)

Revenues are closed to income summary.
Expenses are closed to income summary.
Income summary is closed to capital (retained earnings in a corporation).
Withdrawals (dividends in a corporation) is closed to capital (retained earnings).

Page 207 shows closing entries prepared from an adjusted trial balance.

Typical questions:

Is “accumulated depreciation” closed? No. It is not a temporary account. However, depreciation expense, like all of the other expense accounts, is temporary. Depreciation “expense” would be closed.

Should I close all of the accounts? No. Temporary accounts are located on the lower portion of the trial balance. You will be closing only revenues, expenses, income summary and withdrawals. Leave the other ones alone.

Example of closing entries from an adjusted trial balance

Mr. Smith's Company
Adjusted Trial Balance
As of ____________________

Cash	32,050
Prepaid Insurance	600
Supplies on hand	350
Accounts receivable	1,000
Accounts payable		0
Notes payable		13,000
Revenue received in advance		5,000
Capital [PIC + Retained Earnings]		10,000
Withdrawals [ Dividends]	2,000
Revenue		9,000
Rent expense	400
Wage expense	600
	37,000	37,000

1. Revenues

9,000

Income summary

9,000

To close revenues

2. Income summary

1,000

Rent expense

400

Wage expense

600

To close expenses

3. Income summary

8,000

Capital

8,000

To close income summary

4. Capital [Retained Earnings]

2,000

Withdrawals [Dividends]

2,000