Accrual Accounting Process: Part I

15.511 Corporate Accounting Summer 2004

Professor SP Kothari
Sloan School of Management Massachusetts Institute of Technology

June 11, 2004

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An accountants functions include

Classifying and summarizing, made easier by the repetitive nature of business transactions All repetitive transactions of the same nature are recorded and summarized in one account An account is a storage unit used to classify and summarize money measurements of business activity of a similar nature Each account has a title
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T-Account

Used for illustrative and pedagogical purposes Has two sides

Debit means Left Credit means Right

Created for each type of

Asset Liability Stockholders equity
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Recording changes in Assets and Liabilities

Increases in assets are recorded on the left side of the Taccount Decreases are recorded on the right side of the T-account Reverse for liabilities and stockholders equity Assets = Liabilities + Stockholders equity Assets are on the left side of the Balance Sheet Equation Liabilities and owners equity are on the right side
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How does a T-account look like?

Like a Capital T

Summary of T-account Rules

Assets (cash, receivables, equipment) Increases Decreases

Liabilities (loans payable) Decreases Increases

Owners equity (contributed capital, retained earnings) Decreases Increases

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About T-Accounts

What is one major objective of financial statements? To provide information to users regarding the financial performance of a business Which T-account includes the accountants estimate of financial performance over a given accounting period? Retained earnings (includes current period income) Which financial statement provides the details of the financial performance over a given accounting period? Income statement How do we construct an income statement from the T-account for retained earnings?

Not very easily! But we will try.

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Components of stockholders equity

Common Stock Additional Capital

Retained Earnings Expenses Dividends Revenue

Why record expenses and revenues separately in various T-accounts?

Retained Earnings Rent exp. 800 Salaries 650 Interest exp. 450 Salaries 1,000 Rent exp. 400 Dividends 2,000 Interest exp. 350 1,000 1,100 3,000 200 4,500 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue

Sales Revenue (1,000 + 3,000 + 4,500) Interest Income (1,100 + 200) Rent expense (800 + 400) Salaries expense (650 + 1,000) Interest expense (450 + 350) Net Income

8,500 1,300 (1,200) (1,650) (800) 6,150

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Why record expenses and revenues separately in various T-accounts?

Retained Earnings Rent exp. 800 Salaries 650 Interest exp. 450 Salaries 1,000 Rent exp. 400 Dividends 2,000 Interest exp. 350 1,000 1,100 3,000 200 4,500 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue Sales Revenue 1,000 3,000 4,500 Interest Revenue 1,100 200 Rent Expense 800 400 Salaries Expense 650 1,000
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Interest Expense 450 350 Dividends 2,000

Why record expenses and revenues separately in various T-accounts?

Retained Earnings Rent Exp. 1,200 8,500 Sales Revenue Salaries Exp. 1,650 1,300 Interest Revenue Interest Exp. 800 Dividends 2,000 Sales Revenue 1,000 3,000 4,500 Interest Revenue 1,100 200 Interest Expense 450 350 Dividends 2,000 Salaries Expense 650 1,000 Rent Expense 800 400

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Why record expenses and revenues separately? A Summary

Revenues, expenses and dividends are temporary Taccounts Information on changes in retained earnings - pertaining to a single accounting period - is collected in these temporary accounts At the end of the accounting period, balances in these Taccounts are transferred to Retained Earnings The temporary accounts are set to zero at the end of an accounting period in order to start collecting information for the next period Revenues, expenses and dividend accounts are flow accounts Retained earnings is a stock account In fact, all balance sheet accounts are stock accounts
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Recording expenses: A Summary

Expenses decrease retained earnings. Decreases in retained earnings are recorded on the left side Expenses are recorded on the left side

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Recording Revenues: A Summary

Revenues increase retained earnings. Increases in retained earnings are recorded on the right side (Increase in) revenues are recorded on the right side Decrease in revenues are recorded on the left side
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Recording Dividends: A Summary

Dividends decrease retained earnings Therefore, treated similarly to expenses, but dividends is not an expense Dividends are recorded on the left side

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Expenses and Revenues: Debits and Credits

Retained earnings (in general) has a credit balance. Revenues have credit balance because Expenses and dividends have debit balance because Can retained earnings have a debit balance?
Yes, when cumulative earnings are less than cumulative dividends they decrease retained earnings they increase retained earnings

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Recap: T-Account
Has two sides

Debit means Left Credit means Right

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Recap: Summary of T-account Rules

Assets (cash, receivables, equipment) Increases Decreases

Liabilities (loans payable) Decreases Increases

Owners equity (contributed capital, retained earnings) Decreases Increases

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The Ledger

Accounts are collectively referred to as the ledger Types of accounts

Balance Sheet accounts or real accounts or permanent accounts Income statement accounts or nominal accounts or temporary accounts,

i.e., revenue, expenses, and dividends - all these are subdivisions of retained earnings

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The Recording Process

Journal entries Posting to T-accounts Trial Balance Adjusting entries (Next class) Financial statement preparation

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The Journal

Journal contains a chronological record of the

transactions of a business

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Emilys Bakery Emily contributes $10,000 in cash

Assets Cash +$10,000

Liabilities

Owners Equity Contributed Capital +$10,000

Journal Entry Dr Cash (+A) Cr Contributed Capital (+CC) 10,000 10,000

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The company borrows $3,000 from the bank

Assets Cash +$3,000

Liabilities

Owners Equity

Loans Payable +$3,000

Journal Entry Dr Cash (+A) Cr Loans Payable (+L)

3,000 3,000
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Company purchases equipment for $5,000 cash

Cash -$5,000

Assets Equipment +$5,000

+ OE

Journal Entry Dr Equipment (+A) Cr Cash (-A)

5,000 5,000

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Company performs service for $12,000. The customer pays $8,000 in cash and promises to pay the balance at a later date.

Cash

Assets Receivables +$4,000

L + Owners Equity Retained Earnings +$12,000

+$8,000

Journal Entry Dr Cash (+A) Dr Receivables (+A) Cr Service Revenue (+RE) 8,000 4,000 12,000
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Company pays $9,000 for expenses (wages, interest, and maintenance)

Assets Cash -$9,000

Liabilities

Owners Equity Retained Earnings -$9,000

Journal Entry Dr Expenses (-RE) Cr Cash (-A)

9,000 9,000

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Company pays a dividend of $1,000

Assets Cash -$1,000

Liabilities

Owners Equity Retained Earnings -$1,000

Journal Entry Dr Dividends (-RE) Cr Cash (-A)

1,000 1,000
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Posting

Transactions from the journal are posted to the ledger (we will ignore this step)

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Trial Balance

Trial balance is a listing of all the accounts and their

balances in this order:

Assets Liabilities shareholders equity Revenues Expenses

Duality is an important check of arithmetic accuracy

However, equality of debits and credits in a trial balance does not mean that accounting is error free

Prepared prior to the preparation of financial statements

Complete omission of a transaction Recording an entry in the wrong account Compensating errors

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Emilys Bakery Trial Balance

Debit 6,000 4,000 5,000 Credit

Cash Accounts Receivable Equipment Loans Payable Contributed Capital Retained Earnings Service Revenue Expenses Dividend Total

3,000 10,000 0 12,000 9,000 1,000 25,000

25,000
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Prepare Income Statement For the year ended December 31, 1997
Revenues: Fees earned for service Expenses: Wages, interest, maintenance Net income $12,000 $ 9,000 $ 3,000

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Statement of Retained Earnings For the year ended December 31, 1997
Beginning retained earnings balance Plus: Net income Less: Dividend to stockholder Ending retained earnings balance 0 3,000 1,000 $ 2,000

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Summary
T-accounts

Debit is Left Credit is Right Increases in Assets Debits Increases in liabilities Credits Increases in shareholders equity Credits Expenses are Debits Revenues are Credits

Use balances from T-accounts to prepare financial statements at the end of a fiscal period
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