Financial Statement Preparation

• Chapter focuses on preparing financial statements
• By the end of the chapter, students should be able to describe financial statment process, define key terms, and prepare financial statements from transactions

Financial Transactions Defined

• Events that have an economic impact on a business
• These include sales of merchandise, purchase of inventory, and payment of salaries/utilities
• A system is required to keep track of thousands of annual transactions
• Typically the most common system consists of a general journal and ledger of accounts

System Components

• The basic component of the accounting system is the account
• There is a separate account for every asset, liability, owner equity, revenue and expense that appears on the financial statements
• Cash accounts, accounts receivable, retained earnings, rent expense, and salary expense are some account examples
• The account is a central place for collecting data about transactions that affect specific financial statement items
• Accounts can be physical records like pages in a binder or notebook

Accounts in a Ledger

• Accounts are kept in a ledger of accounts
• Accounts appear in the ledger in the same order as they appear on financial statements
• The order is: current assets, noncurrent assets, current liabilities, noncurrent liabilities, owner equity, revenues, and expenses

Accounting Process

• Analyzing: Reviewing the events and how they affect a business
• Recording: Entering the information into the accounting system
• Classifying: Grouping activities together, like purchases
• Summarizing: explaining the results
• Reporting: Issuing statements to describe results
• Interpreting: Examining statements to determine relationships between information

Journal Entries

• Journals contain the original entry of every transaction
• The transaction date, account titles, dollar amounts, brief explanations, and ledger page numbers are included
• All transactions are recorded in chronological order
• Recording transactions in the journal is called journalizing

Journalizing Analysis

• Determine the accounts that are involved
• Determine what account is to be debited and credited

Journalizing Recording

• First write the date
• Followed by writing the account title and debit dollar amount
• Next write a brief explanation
• Finally, write the account title and credit amount

Ledger Posting

• Entries in the journal are later posted in their proper accounts in the ledger
• Transfer of each transaction from the journal to the ledger is called posting
• The ledger classifies transactions by account type

Ledger Posting Transactions

• Post the debit entry to the debit side of the ledger
• Post the credit entry to the credit side of the ledger
• Cross-index the two records by writing the page in the Folio column

Debit/Credit Method

• The double-entry method is also called the debit/credit method
• Debit refers to value received and credit refers to value parted with
• Bookkeeping is the recording function of accounting based on this debit/credit method
• Assets should always equal the sum of liabilities and owner's equity

Debits v Credits

• Every account has two sides, left and right
• The left side (or column) is referred to as the debit side
• The right side (or column) is the credit side
• Accountants use T accounts or balance column accounts
• Debit refers to value received and credit refers to value parted with.

Recording Transactions

• An increase in an asset is a debit, recorded on the left side of the asset account
• An increase in a liability or owner's equity is a credit, recorded on the right side of the liability or owner's equity account
• A decrease in an asset is a credit, recorded on the right side of the asset account
• A decrease in a liability or owner's equity is a debit, recorded on the left side of the liability or owner's equity account
• Expenses decrease owner’s equity; the debit is recorded on the left side of the expense account
• Revenue increases owner’s equity; therefore, credit is recorded on the right side of the revenue account

Basic Recording Rules

• Each transaction must be recorded separately
• Transactions must be recorded so that assests=liabilities + owners equity
• Each transaction will affect at least two accounts; this is called dual-entry accounting
• Each transaction must be recorded such that debits equal credits

Debit and Credit Rules

• Assets: increasing them has a normal debit balance but when decreasing, credit
• Liabilities: an increase has a normal credit value while a decrease has a debit value
• Owner's equity, capital: increasing has credit normal balance with debit balance for decrease
• Withdrawals: debit for increase with credit for decrease
• Revenue: credit for increase, debit for decrease
• Expenses: debit for increase, credit for decrease

Five Step Transaction Analysis

• Determine the affected Account
• Determine the Account's Category
• Decide the increase or decrease amount
• Apply Rules of Dr. and Cr.
• Note Appearance of T accounts

Trial Balance

• At the end of the accounting period, after posting all journal entries to the ledger accounts, a trial balance is prepared
• The trial balance is a list of all accounts in the order they appear in the ledger, showing their debit or credit balances
• Purpose - check for errors and organize data for making financial statements

Adjustment Process - Cash Basis

• Revenues are recognized and recorded when cash is received, regardless when earned
• Expenses when payment is made, regardless when consumed
• Example: A pharmacist dispenses medication on April 10, but is paid on April 25; revenue is recognized on April 25

Adjustment Process - Accrual Basis

• Revenue is recognized and recorded when compensation is earned, not necessarily when payments are received
• Expenses are recognized when goods/services are consumed, not just when payments are made
• Example: A pharmacist dispenses medication on April 10, but is paid on April 25; revenue is recognized on April 10

Adoption in Pharmacy

• Accrual accounting should be adopted as recommendations for pharmacies
• Inventory is recognized as an asset, rather than an expense
• Enables financial data comparison between different pharmacies, along with industry averages

Adjusting Entries

• Financial statements must be prepared at the end of each period
• Some transactions initiated in one year may not conclude until later, causing matching issues between expenses and revenues
• When a transaction begins in one year but is not concluded until a later one, accountants must adjust records
• Adjusting also occurs - Allocate expenses incurred in the use of equipment (depreciation expense), prepaid and accrued expenses.
• Adjusting entries update various accounts for accurate financial statements
• The adjustment process occurs at the end of the period, after journalizing and posting, but before statement preparation
• Each adjustment affects a balance sheet account and an income statement account, keeping the equation balanced
• These are made for prepaid expenses, supplies, depreciation, and accrued items

Prepaid Expenses

• These occur when an expense is paid in advance
• Examples include prepaid rent, insurance, etc
• Adjustments must be recorded at the end of an accounting period

Inventory Supplies

• For example, on February 13, Williams purchased supplies for $500; the journal is posted as a debit purchase w/ credit to cash
• At the end of December, unused supplies amounted to $200
• An ajusting entry is made to increase expense by 300 and decrease ofice supplies by same amount

Depreciation

• On January 1, Williams purchased office furniture with a $5,100 cost, 5-year useful life, and $100 salvage value
• Annual depreciation = $5,100-$100 / 5 years = $1,000 of depreciation annually
• 12/31 recorded as a debit to depreciation expense - furnitures and fixtures and credit to acculumated depreciation

Accrued Items

• Example: July 1, Williams borrowed $2,500 at 10% interest
• A payment entry would include a debit to cash and credit to loans payable
• On December 31, enter $125 interest expense and credit to accrued interest payable to record interest expense on the loan
• The formula to calculate interest = Principals x Rate x Time

Adjusted Trial Balance

• Journal adjustments are normally performed after preparation of a trial balance
• An adjusted trial balance is prepared to reflect these adjustments
• Accountants then use the adjusted trial balance to prepare various financial statments like income statment, balance sheet etc

Closing Entries

• Balance sheet items are real or permanent accounts because their measurement functions span all accounting periods
• Revenue, expenses, and owner's withdrawal accounts are nominal or temporary because they are specific to one period
• Balances of nominal accounts are reset to zero at the end of each accounting period through journalizing
• Balance sheet accounts accumulate transaction data throughout said business
• Account balances are carried from year to year, making the prior year's ending balance the next year's beginning balance
• Income statement accounts, accumulate data for a set period, like 1 year
• Balances always go back to zero and are reset each accounting period

Closing Process

• Consists of four entries:
  • Close the revenue account and transfer the balance to an income summary account (ISA).
  • Close each expense account and transfer their balances to ISA.
  • Close out ISA and transfer balance to account-capital (sole proprietorship) or retained earnings (corporation)
  • Close withdrawal account and transfer balance to capital account
• ISA is nominal account used only during the closing process
• ISA does not appear on any financial statements
• Closing entries are dated to the end of accounting and are journalized/posted to the ledger
• Made after all other entries have been recorded; has two effects:
  • Transfers net income (or loss) to capital account.
  • Establishes a zero balance in each income statement account to prepare for the next year
• Credit balance indicates net income and a debit balance indicates loss