Preparing Financial Statements

Chapter 3 Preparing Financial
Statements
Objectives
• After this chapter, the student should be able
to:
1. Describe the general process by which
financial statements are prepared.
2. Define general journal, account, ledger of
accounts, postings, transactions, debit and
credit, trial balance, and adjusting entries,and
3. Prepare financial statements from a list of
transactions.
Financial transactions
• Broadly defined as events that have an
economic impact on the business
> sale of merchandise, purchase of
inventory, payment of salaries and utilities
> because a business will experience
thousands of transactions in a year, a system is
needed to track them
> the system most commonly used
consists of a general journal and ledger of
accounts.
Financial transaction
• The basic component of the system is the account
• There is a separate account for every asset, liability,
owner’s equity, revenue and expense that appears on
the financial statements.
> Thus, there are cash accounts, accounts receivable account,
retained earnings account, cash sales accounts, credit sales
accounts, rent expense accounts, and salary expense accounts,
etc
> The account is simply the central place used to collect
information about all transactions that affect a particular item on
the financial statements. Example all transactions that affect
cash would be recorded in the cash account.
> Accounts may be kept in several physical forms e.g. pages of
loose leaf folder or notebook or as computer files.
Accounts
• Accounts are kept in a ledger of accounts
• Accounts appear in the ledger in the
same order as they appear on the financial
statements as follows- current assets,
noncurrent assets, current liabilities, non
current liabilities, owner’s equity, revenues
and expenses.
Accounting Process
• Analyzing: looking at what happened and how the
business was affected.
• Recording: Putting the information into the accounting
system.
• Classifying: Grouping all the same activities (e.g. all
purchases) together
• Summarizing: Explaining the results.
• Reporting: Issuing the statements that tell the results of
the previous functions.
• Interpreting: Examining the statements to determine
how the various pieces of information they contain relate
to each other.
The Journal
• Journals contain the original entry of every
transaction.
• Include the date of transaction, the account
titles, the amounts involved, a brief explanation
of the transaction, and the page of the ledger to
which the entry is later transferred.
• All transactions are recorded chronologically in
the journal
• The process of recording transactions in the
journal is called journalizing
Journalizing
1. On June 1, 20X1, Phil Dill begins a pharmacy
consulting service by investing $1000 in a business,
which he names PD Consulting Service.
Journal
PD Consulting Service
Date Account title Dr. Cr.
& Explanation
6/1/X0 Cash 1,000
P Dill Capital 1,000
Record owner investment
in business
Journalizing in the journal
1. Analysis
>determine the accounts involved
> determine what account is to be debited and
credited.
2. Recording
> write the date
> write the account and amount of debit entry
> write a brief and concise explanation
> write the account and amount of credit entry
The ledger
• Entries in the journal are later posted in
their proper accounts in the ledger
• When each transaction (entry) in the
journal is transferred to a ledger, the
process is called posting.
• The ledger classifies transactions by type
of account- e.g. all cash transactions are
recorded together.
Posting
Ledger of Accounts
Cash P. Dill Capital

____________ _________________
1,000 1,000
Posting in the ledger
1. Transact the debit entry to the debit side
of the ledger
2. Transfer the credit entry to the credit side
of the ledger
3. Cross index the two records by writing
their page in the Folio column.
Debit/Credit Method
• The double entry method is also called the
debit/credit method, where debit refers to value
received and credit refers to value parted with.
• Bookkeeping is the term used to refer to the
recording function of accounting based on this
debit/credit method
• The equation: assets always equal the sum of
liabilities and owner’s equity must be used as a
check to determine correctness of recording.
Debits and 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
• Use of T accounts or balance column
account
Debit refers to value received and credit
refers to value parted with.
Rules Governing the Recording of
Transactions in the Debit/Credit Method
• An increase in an asset is a debit and is recorded on the
left side of the asset account.
• An increase in a liability or owner’s equity is a credit and is
recorded on the right side of the liability or owner’s equity
account.
• A decrease in an asset is a credit and is recorded on the
right side of the asset account.
• A decrease in a liability or owner’s equity is a debit and is
recorded on the left side of the liability or owner’s equity
account.
• Because an expense decreases owner’s equity, it is a
debit and is recorded on the left side of the expense
account.
• Because a revenue increases owner’s equity, it is a credit
and is recorded on the right side of the revenue account.
Four Basic Rules in Recording
Transactions
1. Each transaction must be recorded
separately.
2. The transaction must be recorded so that
assets=liabilities+ owner’s equity.
3. Each transaction will affect at least two
accounts. Because of this, the system is
referred to as dual –entry accounting. The
transaction may affect more than two
accounts, but it must always affect at least two.
4. Each transaction must be recorded such that
debits equal credits.
Rules on Debit and Credit
Account Incr. (Normal Decrease
Categories Balance)
Assets Debit Credit
Liabilities Credit Debit
Owner’s Equity
Capital Credit Debit
Withdrawals Debit Credit
Revenue Credit Debit
Expenses Debit Credit
Five Step Transaction Analysis
1. Account affected
2. Category
3. Incr. or Decr.
4. Rules of Dr. and Cr.
5. Appearance of T accounts
Source: College Accounting 5th edn, Slater, J.,

2002
Questions
Indicate whether each of the following would be a debit or
credit
a) Cash increases by $1,000
b) Accounts payable increase by 1,000
c) Owner’s equity increase by 500
d) Rent expense of 850
e) Revenue of 250
f) Accounts receivable decrease by 400
g) Notes payable increase by 5000
h) Owner’s withdrawal of 100
i) Fixed asset increase by 5,000
j) Inventory increase by 500.
Sample Problem: Phil Dill
Consulting Service
Phil Dill is a pharmacist who provides consultant
pharmacy services to long-term care facilities
(nursing homes). He provides no drug products
to the facilities. Rather, he read patients’ charts
and makes suggestions as to the adequacy of
their drug therapy and how it might be improved.
This example presents the series of transactions
that occur as Phil Dill establishes his business,
PD Consulting Service, and operates it for
several weeks.
Transactions to be Journalized and
Posted
2. During the month, he provides consulting services to
Glow Years Retirement Home. He bills the home for
$500. On June 23, Glow Years pays $300 cash and
agrees to pay the remaining $300 cash and agrees to
pay the remaining $200 in 30 days.
3. On June 28, Dill withdraws $100 in cash from the
business for personal use.
4. On June 29, the rent of $100is paid.
5. On June 30, a $25 phone bill is received. The bill will
not be paid until July 15.
Journalizing
Journal
& Explanation
6/1/X0 Cash 1,000
in business
Journalizing
2. During the month, he provides consulting services to
Glow Years Retirement Home. He bills the home for
$500. On June 23, Glow Years pays $300 cash and
agrees to pay the remaining $300 cash and agrees to
pay the remaining $200 in 30 days.
6/23/X0 Cash 300

Accounts receivable 200
Revenues
500
Record revenues from services
provided to Glow Years Retirement
Homes
3. On June 28, Dill withdraws $100 in cash
from the business for personal use.
6/28/X0 P. Dill Withdrawals 100

Cash
100
Record owner withdrawal
of $100
Journalizing
4. On June 29, the rent of $100 is paid.
6/29/X0 Rent expense 100

Cash
100
Record payment of June

rent
Journalizing
On June 30, a $25 phone bill is received.
The bill will not be paid until July 15.
6/30/X0 Phone expense 25

Accounts payable
25
Record phone expense for
June
Journal
& Explanation
6/1/X0 Cash 1,000

in business
6/23/X0 Cash 300
Revenues 500
provided to Glow Years Retirement Homes

Cash 100
of $100

Cash 100

rent

Accounts payable 25
June
Journalizing and Posting
• Transactions are typically journalized soon
after they occur. They are posted after
some longer period of time. Example, they
may be journalized daily and posted
weekly or monthly.
Posting
Ledger of Accounts
Cash P. Dill Capital

____________ _________________
1,000 1,000
Ledger of Accounts
Cash P.Dill Capital Rent Exp.
________ _____________ __________
1,000 100 1,000 100
300 100
________
1,300
Do the same for accounts receivable, P Dill Withdrawals, Phone Expense

Accounts payable, Consulting revenue
The Trial Balance
• At the end of the accounting period , after all
journal entries have been posted to the ledger of
accounts, a trial balance is prepared.
• The trial balance is a list of all accounts, in the
order in which they appear in the ledger, and
their debit or credit balances.
• The trial balance is prepared to check for errors
and to place data in convenient form for making
financial statements.
Journal
Date Account title & Explanation Dr. Cr.
6/1/X0 Cash 1,000


in business
6/23/X0 Cash 300
Revenues 500
provided to Glow Years Retirement Homes

Cash 100
of $100

Cash 100

rent

Accounts payable 25
June
PD Consulting Trial Balance
Account Name Debit Credit
-----------------------------------------------------------------------------
Cash $1,100
Accounts payable 25
P.Dill Capital 1,000
P. Dill withdrawal 100
Consulting revenue 500
Rent Expense 100
Phone expense 25
__________ ________
Totals $1,525 $1,525
From Journal to Ledger to Trial
Balance
The Adjustment Process
• The cash basis of accounting states that 1) revenues is
recognized and recorded at the point in time when cash
is received, regardless of when it is earned and 2)
expense is recognized and recorded at the point in time
when payment is made for the good or services,
regardless of when it is consumed.
• The accrual basis of accounting states that 1) revenue
is recognized and recorded at the point in time when
compensation is earned regardless of when it is received
and an 2) expense is recognized at the point in time
when the good or services is consumed regardless of
when payment is made
• Example: On April 10, a pharmacist dispenses
prescription medication to a charge patient who pays the
total bill on April 25.
>Under the cash basis of accounting the revenue
would be recognized on April 25.
>Under the accrual basis the revenue would be
recognized on April 10.
• Another example, assume that on August 8, a
pharmacist pays $500 for prescription containers that
will be used in August, September and October .
>Under the cash basis of accounting, the $500
expense is recognized on August 8
>Under the accrual basis, the expenses are
recognized as the vials are consumed.
• The accrual basis of accounting is
recommended for adoption in pharmacy.
• Recognized inventories as an asset and
not an expense.
• Enable comparison of financial data of one
pharmacy to another . Thus can compare
data with industry averages.
Adjusting Entries
• Financial statements must be prepared at the end of
each accounting period (generally the end of each fiscal
year)
• Some transactions begun in 1 year and is not concluded
until a later one. This causes a problem in accurately
matching expenses and revenues in the proper year.
• If transaction begins in 1 year and is not concluded until
a later one, accountants must adjust the accounting
records to indicate what portion of the transaction is a
revenue or expense in each of the affected years.
• Situations in which adjusting entries are used
> allocate expense incurred in the use of
equipment (depreciation expense), prepaid and accrued
expenses.
Adjusting Entries
• The purpose of adjusting entries is to update various
accounts so that the financial statements are more
accurate.
• The adjustment process occurs at the end of the
accounting period after all the transactions have been
journalized and posted, but before the preparation of
financial statements.
• Each adjustment affects both a balance sheet account
and an income statement account, with the accounting
equation always remaining balance.
• Journal adjustments are made for items such as prepaid
expenses, supplies, depreciation and accrued items.
Prepaid Expenses
• Prepaid expenses occurs when an expense is paid in advance.
Example rent and insurance expense paid in advance of the time
covered by the rental contract or insurance policy.
• As an example: March 1, 20X1 Janet Williams , Consultant
Pharmacist, purchased a two year insurance policy for $1440 to
cover contents of her office . The journal entry for the transaction
will be:
03/01/X1 Prepaid insurance 1440
Cash 1440
Record purchase of 2-year insurance policy.
On December 31, the end of William’s financial period, adjusting
entries must be recorded to reflect lapse of some period of
protection from the asset prepaid insurance as follows:
12/31/X1 Insurance expense 600
Prepaid insurance 600
Supplies
• Another example of an asset becoming an expense
involves supplies. For example, assume that on February
13 Williams purchased supplies for $500,Journal entry
would be:
02/15 Office supplies 500
Cash 500
Record purchase of supplies
On December 31, unused supplies amounted to $200.
Therefore an adjusting entry is made to increase supplies
expense by $300 and to decrease office supplies by the
same amount.
12/31 Supplies expense 300
Office supplies 300
Record supplies expense for 20X1.
Depreciation
• On January 1 , Williams purchased office furniture
having a cost of $5,100, a useful life of 5 years and a
salvage value of $100. The journal entry will be:
01/01 Furniture and fixtures 5,100
Cash 5,100
Record purchase of office furnitures.
The annual depreciation would be:
$5,100-$100/5= $1000
Depreciation
Adjusting entry would be made on
December 31 as follows:
12/31 Depreciation expense-Furnitures
and fixures 1,000
Accumulated depreciation (Furn. &
fixt.) 1,000
Record depreciation expense for the
year.
Depreciation
Accumulated depreciation is recorded in the balance sheet:
Furniture and fixtures $5,100
Less Accumulated depreciation 1,000
_______
$4,100
The $4,100 represents the carrying value or book value
of the furniture and fixtures. Depreciation expense listed
in the income statement differs from other operating
expense in that it does not require an outflow of cash.
Accrued Items
• July 1 , Williams borrowed $2,500 from a
bank, with an annual interest rate of 10%
to be repaid when the loan is repaid in one
year. Journal entry would be:
07/01 Cash 2,500
Loans payable 2,500
Record receipt of cash from
bank loan.
Accrued Items
By December 31, interest would accrue
based on the following formula:
Interest = Principal x Rate x Time=($2,500x0.10x 6/12)
Thus an adjusting entry would be made to increase both

interest expense and accrued interest payable by $125.
12/31 Interest expense 125
Accrued interest payable 125
Record interest expense on loan.
Accrued Items
• Williams employed an administrative assistant who was
paid every two weeks. During the last week of
December, the assistant earned $200 that was not paid
until the end of the of the first week of January. As of
December 31 , Williams has incurred an expense and a
liability, but since wages has not been recorded , the
journal does not reflect these facts. An adjusting entry is
thus necessary.
12/31 Salary expense 200
Accrued salaries payable 200
Record salaries expense for the last week of
December.
Adjusted Trial Balance
• Journal adjustments normally are prepared after the
preparation of the trial balance. Thus, it is necessary to
prepare a second trial balance called the adjusted trial
balance to reflect the adjustments.
• Williams’ accountant prepared an adjusted trial balance
• After journalizing and posting the adjustments, the

accountant prepared an adjusted trial balance.
• From the latter balance, the accountant prepared an

income statement , statement of owner’s equity and
balance sheet.
Janet Williams, Consultant Pharmacist
Unadjusted Trial Balance
December 31, 20X1
Cash $6,500
Supplies 800
Prepaid expenses 1,200
Furnitures and fixtures 5,000
Accumulated depreciation $2,200
Accounts payable 4,200
Notes payable 2,500
Janet Williams-capital 6,300
Janet Williams-withdrawals 4,000
Consulting fees earned 25,200
Salaries expense 13,100
Telephone expense 550
Electricity (expense) 2,200
Advertising 750
Miscellaneous expenses 300
_________ _________
$40,400 $40,400
Janet Williams, Consultant Pharmacist
Adjusted Trial Balance
December 31, 20X1
Cash $6,500
Supplies 500
Prepaid insurance 600
Furnitures and fixtures 5,000
Accumulated depreciation $3,200
Notes payable 2,500
Accrued Interest payable 125
Accrued Salaries payable 200
Janet Williams-capital 6,300
Janet Williams-withdrawals 4,000
Consulting fees earned 25,200
Salaries expense 13,300
Telephone expense 550
Electricity (expense) 2,200
Advertising 750
Insurance expense 600
Supplies expense 300
Depreciation expense 1000
Interest expense 125
Miscellaneous expenses 300
_________ _________
$41,725 $41,725
Closing Entries
• Balance sheet items are called real accounts or
permanent accounts because their measurement
functions spans all the accounting periods in the life of
the firm. Example cash account does not cease with the
end of a particular accounting period. Closing balance
on the last day of one accounting period becomes its
opening balance on the next accounting period.
• Not true for revenue , expenses and owner’s withdrawal
accounts. They are called nominal or temporary
accounts because they have a functional life of one
accounting period only in order to permit measurement
of net income.
• The balances of nominal accounts are reset at zero at
the end of each accounting period through the
journalizing of closing entries.
Closing Entries
• Balance sheet accounts accumulate transaction data
over the entire life of the business. The account
balances are carried from year to year such that 1
year’s ending balance becomes the next year’s
beginning balance.
• Income statement accounts, on the other hand,
accumulate transaction data for a set period of time-one
accounting period, usually 1 year.
• This means their balances are removed and reset to
zero. Hence, balances in the revenue and expense
account at the beginning of each accounting period are
always zero. This is necessary so that net income can
be measured for each accounting period.
Closing Entries
• The closing process consists of four entries:
1. An entry to close the revenue account and
transfer its balance to the income summary
account (ISA). The ISA is a temporary account
used to make year end adjusting and closing
entries.
2. An entry to close each of the expense
accounts and transfer their balances to ISA.
Closing Entries
3. An entry to close the ISA and transfer its balances to
the owner’s equity account-either capital (for sole
proprietorship)or retained earnings (for a corporation).
4. An entry to close the owner’s withdrawal account ( of a
sole proprietorship) or the dividends paid account (of a
corporation)and transfer the balance to the capital
account.
The income summary account (ISA) is a nominal
account that is used only during the closing process.
Since it does not represent a specific item on the
financial statements , it does not appear in any of them
Closing Entries
• Closing entries are dated as of the last day of the
accounting period. They are journalized and posted on
the ledger. Closing entries are made after all other
entries have been recorded. Closing process has two
effects:
1. It transfers net income (or net loss) to the capital
account. Before it is closed, the ISA contains revenue
on the credit side and expenses on the debit side.
Hence a credit balance indicates net income and a
debit balance indicates net loss.
2. It establishes zero balance in each of the income
statement accounts so they are ready for use in the
next accounting period.
Journal
Date Account title
& Explanation Dr. Cr.
5/31/X1 Consulting revenue 14,500

Income summary account 14,500
Close consulting to income summary account
5/31/X1 Income summary account 13,500
Rent expense 1,200
Phone expense 300 Salary expense
12,000
Close expense to income summary
5/31/X1 Income summary account 1,000
P. Dill Capital 1,000
Close income summary to capital
5/31/X1 P. Dill capital 500
P. Dill Withdrawal 500
Close owner’s withdrawal to capital
Ledger of Accounts
Cash Rent Expense
P. Dill Capital
950 1,000 1,200
Accounts Receivable P. Dill withdrawal Phone Expense
1,100 500 300
Accounts Payable Consulting Revenue Salary Expense
500 12,000
14,500
Balance after consulting revenue to close to
Income statement summary
Income summary acct. Consulting Revenue

14,500 14,500 14,500
Balance after expense account are closed to ISA

Income summary acct. Rent Expense Phone Expense Salary Expense
13,500 14,500 1200 1200 300 300 12,000 12,000
Balance after ISA is closed to capital account

Income summary account P. Dill Capital
13,500 14,500 1,000
1,000 1,000
0
Balance after withdrawal account is closed to capital
P. Dill Withdrawal P. Dill Capital
500 500 1,000

1,000
500
0
1,500
Ledger of Accounts
Cash Rent Expense
P. Dill Capital
950 1,500
1,100
550
Ledger of accounts of PD Consulting service after closing

Which of the following accounts must be closed at
the end of the accounting period?
1. Cash
2. Accounts receivable
3. Sales
4. Rent expense
5. Owner’s withdrawal
6. Consulting revenues
Trial Balance
May 31, 20X1

Cash $ 950
Accounts receivable 1,100
Accounts payable 550
Consulting Revenue 14,500
Rent Expense 1,200
Phone Expense 300
Salary Expense 12,000
_______ _______
Total $16,050 16,050
Trial Balance
May 31, 20X1

Cash $ 950
Accounts payable 550
Consulting Revenue 14,500
Rent Expense 1,200
Phone Expense 300
Salary Expense 12,000
_______ _______
Total $16,050 16,050
Income Statement
For the year ended, May 31, 20X1
Consulting revenue $14,500

Expenses
Rent $1,200
Phone 300
Salary 12,000
______
Total 13,500
______
Net income $1,000
Statement of Capital
Capital, P. Dill, May 1, 20X1 $1,000

Add Net Income 1,000
Less P. Dill Withdrawal 500
________
Capital P. Dill Capital, May 31, 20X1 $1,500
Balance Sheet
May 31, 20X1
Assets
Cash $950
Total assets $2,050
Liabilities
Accounts payable $550
Total liabilities $550
Owner’s equity
P. Dill Capital $1,500
Total liabilities plus Owner’s equity $2,050
Ledger of Accounts
Cash Rent Expense
P. Dill Capital
950 1,000 1,200
1,100 500 300
500 12,000
14,500
Income Statement
Consulting revenue $14,500

Expenses
Rent $1,200
Phone 300
Salary 12,000
______
Total 13,500
______
Net income $1,000
Balance Sheet
May 31, 20X1
Assets
Cash $950
Total assets $2,050
Liabilities
Accounts payable $550
Total liabilities $550
Owner’s equity
P. Dill Capital $1,500
Total liabilities plus Owner’s equity $2,050
Assume Piedmont Pharmacy’s fiscal year ends
on December 31. Which of the following would
require adjusting entries?Explain your answer.
a) Rent for November was paid the following December.
b) Rent for December was paid the following January.
c) Sales expense of $5000 was incurred and paid in December.
d) Salary expense of $2,500 was incurred , but not paid , during
the last 2 weeks of December. Salaries will be paid on
January 14.
e) Credit sales of $1,000 are made during the last 2 weeks of
December. Payment for these sales will be made during the
following January.
f) A car is purchased and paid for , in cash , on March 31.
g) A computer with an estimated life of 5 years is purchased on
April 30. The money used to buy the computers was
borrowed from a bank on a 5 year loan. Both principal and
interest are due in 5 years.
Trial Balance
New Service Company
December 31, 20X2
---------------------------------------------------------------------------------------------------------------------------------------
-
Cash $4,000
Supplies 3,000
Equipment 40,000
Accumulated depreciation eqpt. 4,000
Notes payable 10,000
Accrued interest payable 375
J. Smith Capital 39,000
Consulting revenue
60,000
Salary expense 46,200
Utility expense 1,800
Miscellaneous expense 1,000
Depreciation expense 4,000
Supplies expense 5,000
Interest expense 375
__________ ________
Totals $122,375 $122,375
Prepare the necessary closing entries & Financial Statements

Preparing Financial Statements

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Preparing Financial Statements

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Chapter 3 Preparing Financial

Cash P. Dill Capital

Source: College Accounting 5th edn, Slater, J.,

6/23/X0 Cash 300

6/28/X0 P. Dill Withdrawals 100

6/29/X0 Rent expense 100

Record payment of June

6/30/X0 Phone expense 25

Record owner investment

6/28/X0 P. Dill Withdrawals 100

6/29/X0 Rent expense 100

Record payment of June

6/30/X0 Phone expense 25

Cash P. Dill Capital

Do the same for accounts receivable, P Dill Withdrawals, Phone Expense

6/1/X0 Cash 1,000

Record owner investment

6/28/X0 P. Dill Withdrawals 100

6/29/X0 Rent expense 100

Record payment of June

6/30/X0 Phone expense 25

Thus an adjusting entry would be made to increase both

• After journalizing and posting the adjustments, the

• From the latter balance, the accountant prepared an

5/31/X1 Consulting revenue 14,500

Accounts Receivable P. Dill withdrawal Phone Expense

1,100 500 300

Accounts Payable Consulting Revenue Salary Expense

Income summary acct. Consulting Revenue

Balance after expense account are closed to ISA

13,500 14,500 1200 1200 300 300 12,000 12,000

Balance after ISA is closed to capital account

P. Dill Withdrawal P. Dill Capital

500 500 1,000

Accounts Receivable P. Dill withdrawal Phone Expense

Accounts Payable Consulting Revenue Salary Expense

Ledger of accounts of PD Consulting service after closing

Account Name Debit Credit

Account Name Debit Credit

Consulting revenue $14,500

Capital, P. Dill, May 1, 20X1 $1,000

Accounts Receivable P. Dill withdrawal Phone Expense

1,100 500 300

Accounts Payable Consulting Revenue Salary Expense

Consulting revenue $14,500

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