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Chapter 4:
The Mechanics of Financial
Accounting
2
Chapter 4: The Mechanics of
Financial Accounting
The first step in the accounting process is
transaction analysis.
 This process examines relevant, objectively
measurable economic events through their
effect on the accounting equation:
Assets = Liabilities + Equity

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Now look at E4-2 Spreadsheet
Using a spreadsheet approach, analyze
the transactions. (Spreadsheet on next
slide.)
 Note that effects may be on both sides of
the equation, in the same direction, or
effects may be on one side of the
equation with offsetting directions.

4
Exercise 4-2 Spreadsheet
1.
2.
3.
4.
5.
6.
Cash + A/R + Land = N/P + CC + RE
30,000
30,000
=
(20,000)
20,000 =
9,000
= 9,000
8,000 Rev.
8,000
=
(5,500)
(5,500) Exp.
=
_____
_____= _____
_____
_____
(500) _____
(500) Div.
Tot. 13,000 + 8,000 + 20,000 = 9,000 + 30,000 + 2,000
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Exercise 4-2 Financial Statements
Income Statement
Revenues
Expenses
Net Income
$8,000
5,500
$2,500
Statement of Retained Earnings
RE (beginning)
$ 0
Add: Net Income 2,500
Less: Dividends
(500)
RE (ending)
$2,000
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Exercise 4-2 Financial Statements
Balance Sheet
Assets
Cash
$13,000
A/R
8,000
Land
20,000
Total
$41,000
Liabilities and S.E.
N/P
$ 9,000
CS
30,000
RE (ending)
2,000
Total
$41,000
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Now look at E4-2 Spreadsheet
Note that the transaction analysis was
relatively simple with a few transactions
and a few accounts. However, with
thousands of transactions and hundreds
of accounts, the spreadsheet program is
not sufficient.
 Therefore accountants use a “double
entry” system based on debits and
credits.

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Double Entry Accounting
Debit (dr) - means an entry to the left
hand side of an account.
 Credit (cr) - means an entry to the right
hand side of an account.
 Note that a debit or credit, per se, does
not indicate increase or decrease.
 To decide the effect of a debit or credit,
the type of account must be considered.

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Effect of Debits and Credits


Based on the accounting equation, we can increase or decrease
various accounts depending on their classification:
Note that we use debits and credits instead of plusses and
minuses.
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The following rules can be derived from
the basic formula:





Assets have normal debit balances and are
increased with a debit.
Liabilities and equities have normal credit
balances and are increased with a credit.
Revenues (a part of equity) have normal credit
balances and are increased with a credit.
Expenses (which decrease equity) have normal
debit balances and are increased with a debit.
Dividends (which decrease equity) have a
normal debit balance and are increased with a
debit.
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The Format of a Journal Entry
To initially record transactions, we use a journal
entry to represent the debits and credits.
For example, in E4-2, Item 1:
Debit Credit
Cash
30,000
Common Stock
30,000
Note that the debit is to the left and the credit is
to the right. First we list the account (left hand
entry on top), then the amount.
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Now back to E4-2, and prepare the
other journal entries:
2: Purchased land for $20,000 cash.
Land
20,000
Cash
20,000
3: Borrowed $9,000 cash from bank.
Cash
9,000
Notes Payable
9,000
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Now back to E4-2, and prepare the
other journal entries:
4: Provided services (on account) $8,000.
Accts. Receivable 8,000
Service Revenue
8,000
5: Paid $5,500 cash for expenses.
Expenses
5,500
Cash
5,500
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Now back to E4-2, and prepare the
other journal entries:
6: Paid $500 cash dividend to owners.
Dividends
500
Cash
500
Note that dividends is a contra equity and
reduces retained earnings.
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The Accounting Cycle
(more detail in Appendix 4A)
Components of the accounting cycle include:
A. Preparation of Daily Journal Entries
-Post to the General Ledger
-Unadjusted Trial Balance
B. Preparation of Adjusting Journal Entries
-Post to the General Ledger
-Adjusted Trial Balance
C. Financial Statements
D. Closing Journal Entries
-Final Trial Balance
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A. Daily Journal Entries (DJEs)

The first step in the accounting process.
 Prepared for daily activity.
 Usually journalized in special journals for
efficiency, but we will record in “General Journal”
format.
 Identified through a document flow:
– cash receipt, record a cash sale
– charge receipt, record a credit sale
– bank note, record a notes payable
– employee time card, record wages

E 4-2 transactions are DJEs.
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Another Example of DJE

Often, investments and noncurrent assets are
sold for more or less than the amounts at which
they are carried on the balance sheet. In such
cases a gain (if a credit) or loss (if a debit) must
be recognized.
 Ex: Land that cost $10,000 is sold for $11,000
cash. Prepare the GJE:
Cash
11,000
Land
10,000
Gain on Sale of Land
1,000
Note: gains are a form of revenues and losses
are a form of expenses on the income statement.
 The sale of inventory is recorded in a different
manner – discussed in Chapters 4 and 7.
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The General Ledger (G/L)
The G/L serves as a place to “total”
amounts by account titles.
 After DJEs and AJEs are recorded, they
are posted (by account) to the G/L.
 We will use “T” accounts to represent G/L
accounts where needed.
 Appendix 4A discusses T accounts in
more detail.

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Back to E4-2: Posting to G/L
Now post transactions (for cash) to “T” account:
Cash
30,000
9,000
20,000
5,500
500
Bal. 13,000
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Unadjusted Trial Balance

Trial balances are prepared throughout the
accounting cycle.
 The Unadjusted Trial Balance represents G/L
totals (by account) at a particular point in time.
 For E4-2, the Unadjusted Trial Balance would
consist of a list of all of the ending debit or
credit balances taken from the various “T”
account totals (illustrated on the next slide).
 The Unadjusted Trial Balance is a preliminary
total, and is a starting point for the Adjusting
Journal Entries (discussed later in this
chapter).
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Unadjusted Trial Balance - Exercise 4-2
(after posting and totaling G/L accounts)
Cash
Accounts Receivable
Land
Notes Payable
Contributed Capital
Retained Earnings
Totals
Debit
13,000
8,000
20,000
Credit
9,000
30,000
2,000
41,000
41,000
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B. Adjusting Journal Entries (AJEs)
Prepared at the end of the accounting
period to align revenues and expenses
(matching).
 Usually NO document flow to trigger
recording.
 Based on the accrual system of
accounting which records revenues as
earned and expenses as incurred (rather
than based on cash flows).

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Types of AJEs
1. Accrual of expenses
2. Accrual of revenues
3. Deferrals of expenses
4. Deferrals of revenues
5. Revaluation adjustments
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Accrual System vs. Accrual AJEs



The “accrual system of accounting” and
“accrual of revenues and expenses” are both
discussed in this chapter.
Note that the “accrual of revenues and
expenses” is a subset of the AJEs discussed
in this chapter.
In comparison, the “accrual system of
accounting” refers to the entire process of
revenue and expense recognition, and relates
to the definitions of matching and revenue
recognition discussed in Chapter 3.
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1. Accrual of Expenses

Probably the most common type of AJE.
Ex: accrue wages at the end of the period:
Wages Expense
xx
Wages Payable
xx
 Note: this is a “skeletal” journal entry, where the
“xx” simply indicate values to be calculated later.
The focus is on the account and direction.
 Other examples of expense/payable include
interest, rent, taxes.
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2. Accrual of Revenues
For revenues that have not yet been
recorded at the end of the period.
 Ex: accrue interest revenue:
Interest Receivable
xx
Interest Revenue
xx
 Another example of receivable/revenue
accruals relates to rent revenue, where
the rental payment has not yet been
received.

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3.Deferral of Expenses

This category of AJE relates to the concept of
asset capitalization and the matching
principle.
 Asset capitalization occurs when a cost (with
future economic benefit) is incurred. An asset
is recognized at that time.
 As the asset is “used up” in the generation of
revenue, the related cost is recognized as an
expense (matching).
 Some expenses are deferred for a short period
of time (Supplies Expense), and some
expenses are deferred for many years
(Depreciation Expense).
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3.Deferral of Expenses

Example: Purchase 1 year insurance policy.
Daily JE at time of purchase:
Prepaid Insurance
xx
Cash
xx
AJE at end of the period (for the portion that
has been used):
Insurance Expense
xx
Prepaid Insurance
xx
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3.Deferral of Expenses


Example: purchase of inventory.
Daily JE at time of purchase:
Merchandise Inventory xx
Cash
xx
AJE at end of the period (for the portion that
has been sold):
Cost of Goods Sold
xx
Merchandise Inventory xx
Note: the treatment of merchandise inventory
is expanded significantly in Chapter 7.
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3.Deferral of Expenses


Example: purchase of equipment.
Daily JE at time of purchase:
Equipment
xx
Cash
xx
AJE at end of the period (for the portion that
has been used):
Depreciation Expense
xx
Accumulated Depreciation
xx
Note: Accumulated Depreciation is a contra
asset account, and is presented as an offset
to Equipment on the balance sheet (more in
Chapter 9).
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4.Deferral of Revenues
Cash is received from customer before
goods/services are delivered (before
revenue can be recognized).
Ex: Received subscription in advance.
Daily JE at time cash received:
Cash
xx
Unearned Revenues
xx
AJE at end of the period (for portion):
Unearned Revenues
xx
Subscription Revenues
xx

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5. Revaluation Adjustments

These are adjustments that do not fall into
the categories of accruals or deferrals.
 They serve to restate certain accounts to
keep their reported values in line with existing
facts.
 Examples include the revaluation of:
– short-term investments
– inventories
 More in later chapters.
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P4-8
a. AJE at 12/31 for supplies used:
(85,000 - 30,000 unused = $55,000 used)
Supplies Expense
55,000
Supplies
55,000
b. AJE at 12/31 for rent owed:
Rent Expense
2,400
Rent Payable
2,400
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P4-8
c. AJE at 12/31 for services performed:
(18,000 x 2/3 = 12,000 earned by 12/31)
Unearned Revenue
12,000
Service Revenue
12,000
d. AJE at 12/31 for depreciation:
(500,000/10 = 50,000 per year)
Depreciation Expense 50,000
Accumulated Depr.
50,000
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P4-8
e. AJE at 12/31 for interest owed to the bank
on the notes payable. Use Principal x Rate
x Time to calculate the interest owed from
July 1 to Dec. 31 (6 months):
P
x
R
x
T
10,000 x .12 per year x 6/12 of a year
Interest Expense
Interest Payable
600
600
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P4-8
f. AJE at 12/31 for amount owed for
advertising:
Advertising Expense
28,000
Advertising Payable
28,000
g. AJE at 12/31 for insurance used from 7/1
to 12/31:
($350 x 1/2 year)
Insurance Expense
175
Prepaid Insurance
175
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Adjusted Trial Balance
The Adjusted Trial Balance reflects totals
after the AJEs are posted to the general
ledger.
 The balance sheet accounts reflect the endof-year balances, and the income statement
accounts reflect the proper revenues and
expense to be recognized for the year.
 This list of accounts and amounts is used to
prepare the balance sheet and income
statement.

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C. Preparation of Financial Statements
from the Adjusted Trial Balance
The amounts in the Adjusted Trial Balance
are used to prepare the balance sheet and
the income statement.
 The statement of stockholders’ equity
(SSE) requires some additional
investigation.
 Remember from Chapter 3 that the SSE
shows all activity during the period for
contributed capital and retained earnings.

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Contributed Capital and
Retained Earnings
The contributed capital in the adjusted trial
balance is an ending balance; the ledger
account must be examined to see if any
activity (like issue of additional stock)
occurred.
 The retained earnings on the adjusted trial
balance is a beginning balance; while the
revenues, expenses and dividends are
displayed in the trial balance, they have not
yet been included in (closed to) retained
earnings.

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Financial Statements

The financial statements for Kelly Supply (next 4
slides), and other examples in text, can be used
as guidelines to prepare financial statements.
 The financials should be prepared in the following
order:
– income statement (I/S)
– statement of stockholders’ equity (SSE)
– balance sheet (B/S)
 Note that the statement of cash flow (SCF) is not
prepared from the adjusted trial balance, but from
a detailed analysis of the cash flow activities of
the company.
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Financial Statements

Comments on the preparation of financial
statements from adjusted trial balance (ATB):
– revenue and expense balances from the ATB
are carried to the income statement.
– net income is carried to the retained earnings
column in the SSE.
– other activity, like dividends and issue of stock,
are reflected in the SSE.
– ending balances in the SSE are carried to the
stockholders’ equity section of the balance
sheet.
– asset and liability balances from the ATB are
carried to the balance sheet.
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Financial Statement Examples - Kelly Supply
Kelly Supply
Income Statement
For the Year Ended December 31, 2006
Revenues:
Sales
Interest revenue
Total revenues
Expenses:
Cost of goods sold
Wages expense
Rent expense
Interest expense
Depreciation expense
Amortization expense
Total expenses
Net income
$27,000
50
$27,050
$ 9,000
8,000
1,000
3,000
3,000
500
. 24,500
$ 2,550
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Kelly Supply
Statement of Stockholders’ Equity
For the Year Ended December 31, 2006
Beginning balance
Common stock issuances
Net income
Dividends
Ending balance
Common
Stock
$30,000
10,000
40,000
Retained
Earnings
$5,000
2,550
(1,000)
$6,550
Total
$35,000
10,000
2,550
(1,000)
$6,550
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Kelly Supply
Balance Sheet
December 31, 2006
Assets:
Cash
Accounts receivable
Interest receivable
Merchandise inventory
Prepaid rent
Machinery
Less: Accumulated depreciation
Patent
Total assets
$ 9,500
22,000
50
13,000
2,000
$26,000
8,000
18,000
4,500
$69,050
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Kelly Supply
Balance Sheet
December 31, 2006
Liabilities and stockholders’ equity:
Accounts payable
Wages payable
Interest payable
Dividends payable
Unearned revenue
Short-term notes payable
Long-term notes payable
Common stock
Retained earnings
Total liabilities and stockholders’ equity
$ 5,000
1,000
2,000
1,000
1,000
2,500
10,000
40,000
6,550
$69,050
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D. Closing Journal Entries (CJEs)
Prepared after the financial statements
have been completed.
 Close temporary accounts to retained
earnings, so that the balances in those
accounts at the start of the next accounting
period will be zero.
 Temporary accounts include revenues,
expenses and dividends.
 The final trial balance after closing will
display only permanent, balance sheet
accounts.

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