1. Accounting Fundamentals Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03

2. Chapter 4: The Mechanics of an Accounting System Agenda  An Overview of the General Ledge System  Adjusting Journal Entries  Closing Entries

3. Agenda t An Overview of the General Ledge System

4. The Traditional Way to Keep the Books: The General Ledger System THE ACCOUNTING CYCLE : t Transactions occur in the normal course of business. We record them in our records with a JOURNAL ENTRY. t Journal entries are posted to the GENERAL LEDGER. t ADJUSTING ENTRIES are made and posted. Transactions Financial Statements

5. Accounting cycle continued... t A trial balance can be prepared at any time to make sure we haven’t made an error with the debit-credit part of the accounting system. More about that after we learn the nuts and bolts about DEBITS and CREDITS... t Financial statements are written. t Closing journal entries are made and posted (and a post-closing trial balance may be prepared).

6. Terminology t What’s a general ledger? u A big book of accounting records in which every page is an “account.” t What’s an account? u A page in the general ledger that is devoted to keeping track of an individual asset or liability or type of owners’ equity. u How many are there? As many as the business find necessary for its record keeping.

7. Accounts…debits and credits t Each account can be increased or decreased. t For example, CASH can be increased (when it is collected) and decreased (when it is disbursed). t Each item on the balance sheet is either an account or a composite of several accounts.

8. How this debit/credit stuff works: DEBIT means LEFT side CREDIT means RIGHT side T We can represent an account with a T, where one side is the place where we put the increases and the other side is for decreases. The left side is always called the debit side. When we put something on the left side of an account, we are debiting the account. The right side is always called the credit side. When we put something on the right side of an account, we are crediting the account.

9. How this Debit/Credit Stuff Works Assets= Liabilities+ Owners’ Equity Revenue Expense + Increases in assets go on the left. Debits increase assets.

10. Assets= Liabilities+ Owners’ Equity Revenue Expense + __ How this Debit/Credit Stuff Works Decreases in assets go on the right. Credits decrease assets.

11. Assets= Liabilities+ Owners’ Equity Revenue Expense + __ How this Debit/Credit Stuff Works Increases in liabilities go on the right. Credits increase liabilities. +

12. Assets= Liabilities+ Owners’ Equity Revenue Expense + __ How this Debit/Credit Stuff Works Decreases in liabilities go on the left Debits decrease liabilities. + __

13. Owner’s Equity Accounts Contributed Capital and Retained Earnings) are increased with credits and decreased with debits. Assets= Liabilities + Owners’ Equity Revenue Expense + __ + + __

14. Revenue and Expense Accounts t Revenue and expense accounts are not considered “owners’ equity” accounts--even though they effectively increase or decrease equity! t They are called income statement accounts, often called temporary or nominal accounts.

15. Revenue Accounts t An increase in a revenue causes an increase in owners’ equity--so the debits and credits will be the same for revenue accounts as they are for owners’ equity: Credits increase revenue accounts and debits decrease revenue accounts. Revenue accounts keep track of all the company’s earnings from sales and services.

16. Revenues are increased with credits and decreased with debits. Assets= Liabilities + Owners’ Equity Revenue Expense + __ + + __ + __

17. Expenses reduce owners’ equity, so the debits and credits are opposite of those for the OE accounts: debits increase expenses, credits decrease expenses. Assets= Liabilities + Owners’ Equity Revenue Expense + __ + + __ ++__ __

18. SUMMARY: DOUBLE-ENTRY ACCOUNTING t Each account can be increased or decreased. t Debit means “left side” t Credit means “right side” t Asset and expense accounts are increased with debits and decreased with credits. t Liability, equity, and revenue accounts are increased with credits and decreased with debits.

19. T-Accounts + Increase ASSETS In a transaction that increases an asset, put that amount on the left.

20. T-Accounts + Increase ASSETS - Decrease In a transaction that increases an asset, put that amount on the left. In a transaction that decreases an asset, put that amount on the right.

21. T-Accounts + Increase ASSETS - Decrease In a transaction that increases an asset, put that amount on the left. In a transaction that decreases an asset, put that amount on the right. In our accounting records, we never cross out or subtract or change a number. Instead, we use debits and credits to change the balance in an account.

22. T-Accounts + Increase ASSETS - Decrease In a transaction that increases an asset, put that amount on the left. In a transaction that decreases an asset, put that amount on the right. Calculate the balance in an asset account at any time by adding the amounts on the left and subtracting the amounts on the right.

23. T-Accounts: Assets CASH CASH debits increase assets e.g., when we receive cash, we debit the CASH account DEBITS on the left!!

24. T-Accounts: Assets CASH CASH debits Increase assets credits decrease assets e.g., when we receive cash, we debit the CASH account Credits on the right!! e.g., when we disburse cash, we credit the CASH account

25. T-Accounts: Liabilities and Equity Accounts Payable Accounts Payable debits liabilities credits liabilities e.g., when we pay off some of our accounts payable Credits on the right!! Debits on the left!! e.g., when we record an amount we owe someone

26. T-Accounts LIABILITIES + Increase-Decrease EQUITY -Decrease+ Increase Additions to these accounts are put on the right. Deductions from these accounts are put on the left. Equity accounts work like liability accounts:

27. What about Revenue and Expense Accounts? revenues Since revenues increase owners’ equity, they are increased with credits---just like owners’ equity accounts. Service Revenue + Revenue accounts are rarely debited..

28. expenses Since expenses decrease owners’ equity, they are increased with debits---just the opposite of owners’ equity accounts. Expenses + Expense accounts are rarely credited. What about Revenue and Expense Accounts?

29. expenses Since expenses decrease owners’ equity, they are increased with debits---just the opposite of owners’ equity accounts. Expenses + Expense accounts are rarely credited.. Remember, an expense account is simply a list of the company’s expenses. So as we incur expenses, we increase the expense account. That is, we are adding to our list of expenses. What about Revenue and Expense Accounts?

30. What is a journal and a journal entry? t A journal is a book where a chronological record of transactions is recorded. t Only basic information is contained in the journal. t A “journal entry” is just a recorded transaction. t Because of the design of the debit/credit system to go with the accounting equation, in every journal entry there are equal dollar amounts of debits and credits.

31. t Journal entries are recorded chronologically as the transactions occur: e.g., Services are rendered for $100 cash: Cash100 Service Revenue100 An explanation goes here. t Journal entries are written in a journal and then posted to the general ledger accounts (our t-accounts) How do journal entries relate to T-Accounts?

32. They are then posted to the General Ledger (our t-accounts) CASH SALES 100

33. Assets Liabilities Assets Liabilities + increase - decrease - decrease + increase Owners’ Equity -decrease+ increase Summary of Debits and Credits Revenues Expenses + +

34. Summary of Journal Entries t Assets and Expenses are increased with debits. t Assets include u Cash u A/R u Inventory u Supplies u Prepaid Rent u Equipment t Liabilities and Owners’ Equity and Revenue accounts are increased with credits. t Liabilities include all PAYABLES. t Equity accounts include: u Contributed Capital u Retained Earnings

35. ABC Company received $4,000 from a client for services to be performed at a future date. CashUnearned Revenue Example I $4000

36. ABC Company paid $1,500 to employees for work completed. 1,500 Example II CashSalary Expense

37. ABC Company paid $3,000 for a new piece of office equipment. $3,000 Cash Equipment $3000 Example III

38. Recognized one-fourth of the $4,000 unearned revenue (received in a previous transaction) because one- fourth of the work was completed. * previously recorded Example IV Unearned RevenueRevenue 10004000* 1000

39. Trial Balance: a list of each account and its debit or credit balance. Since debits = credits in all journal entries, at any point in time we should be able to take the balances in all of our general ledger accounts and confirm that DEBITS = CREDITS for all accounts together. debitscredits

40. Agenda t Adjusting Journal Entries

41. Adjusting Entries t Before financial statements are prepared, adjusting entries must be recorded to make sure that all accounts are properly stated and that nothing has been omitted. t Adjustments need to be made for u Accruals u Deferrals

42. Adjusting for Accruals t ACCRUALS--actions that have been completed but for which the cash has not changed hands (and the events are not yet recorded) u ABC Company has a CD on which $500 of interest had been earned during the year but not yet received (or recorded). Interest receivableInterest revenue 500

43. Adjusting for Deferrals t Deferrals--dollars have been exchanged and recorded before the action is completed u ABC Company paid $600 for rent on December 1. The rent was for three months, beginning in December. When they paid it, ABC recorded it as Prepaid Rent. Now, on 12/31, one month’s worth of rent has been used. * previously recorded Prepaid RentRent Expense 600*200

44. The Goal of the Whole Process t Financial Statements that reflect the financial condition and transactions of the company u Balance Sheet u Income Statement u Statement of Changes in Owners’ Equity u Statement of Cash Flows

45. Agenda t Closing Entries

46. Closing Entries t All temporary accounts (income statement accounts and distributions) are closed at the end of the accounting period, after the statements are prepared. t Their balances are brought to ZERO, and the balancing entry is made to the retained earnings account.

47. Closing Entries t Since revenue and expense accounts keep track of transactions for a period of time, we need them to be zero at the end of an accounting period. t To do this, we close them to retained earnings. t This effectively kicks them from the income statement to the balance sheet Revenues & Expenses Income Statement Balance Sheet

48. Journal Entries to Close Revenue and Expense Accounts: Closing Entries t Revenue accounts have credit balances, so we must DEBIT them to close them (to get a zero balance) t What should we credit? RETAINED EARNINGS

49. Closing continued... Closing continued... t To close expense accounts, we should credit the expense account and debit the Retained Earnings account. t We are emptying the revenue and expense accounts… t All revenue and expense accounts will have a balance of ZERO after we close them.

50. T-accounts An example of closing Service Revenue Salary Expense Rent Expense Retained Earnings Bal.XXX 5000 1000 1500 5000 1000 1500 Net Income

51. Retained Earnings Beginning balance + Net Income Ending balance The DISTRIBUTIONS (to owners) account is closed with a credit, since it has a debit balance, and a debit to RETAINED EARNINGS. Distributions $xxx One More Account to Close

52. Beginning balance + Net Income Ending balance - Distributions Retained Earnings A Final Look at Retained Earnings Account

53. The Post-closing Trial Balance: A trial balance written after closing the books is called a post-closing trial balance sheet. ONLY the BALANCE SHEET ACCOUNTS -- the revenue and expense accounts have zero balances. What accounts will be on this trial balance?