Frontmatter

• Homework 1 due next week
  • Available on eLearn
  • Submit on eLearn
• Covers topics from today’s session

Learning objectives

History: Before double entry

• 8500 BCE: Shaped clay tokens represent commoditites
• 200 BCE: Arabic numerals (except 0)
• 600 CE: 0 developed
• 800 CE: 10-digit numerals spread throughout Europe

http://www.schoyencollection.com/mathematics-collection/pre-literate-counting/bulla-envelope-ms-4631

*Note: This slide is based on a history lecture by Dr. Pierre Liang at Carnegie Mellon from October 2017

History: Double entry

*Note: This slide is based on a history lecture by Dr. Pierre Liang at Carnegie Mellon from October 2017

History: Journal entries

Images from Littleton 1928 TAR.

History: Journal entry evolution

Shakespeare likely did this sort of work for the British Navy! (Source: Reynolds 1974 JAR)

History: Impact

The Principles of Book-keeping by Double Entry constitute a theory which is mathematically by no means uninteresting: it is in fact like Euclid’s theory of ratios an absolutely perfect one, and it is only its extreme simplicity which prevents it from being as interesting as it would otherwise be.
– Arthur Cayley, FRS, The Principles of Book-keeping by Double Entry, 1894.

Bookkeeping has become a real technology instead of a simple clerical routine, and in addition there has grown up a profession of accounting which reaches quite beyond bookkeeping.
– A. C. Littleton, The Evolution of the Journal Entry, 1928.

Debits and credits

The side of an account that increases its balance is called the account’s normal balance

Debits always equal credits for a transaction

Representing accounts: T-accounts

Normal balances

Review: Debits & credits

1. Where do debits go?
2. Where do credits go?
3. What do debits equal?
4. What do credits equal?

Review: Debits & credits

1. Where do debits go?
   • Left!
2. Where do credits go?
   • Right!
3. What do debits equal?
   • Credits!
4. What do credits equal?
   • Debits!

Accounts

Source documents

General journal

DR = CR for each entry

Constructing journal entries

Constructing journal entries

1. Get the in class activity spreadsheet
   • Session_2_Activity.xlsx
2. We’ll go through the first three transactions together
   • Journal entries
3. Journal the next 11 transactions with your group in the blue tab of the spreadsheet
   • We’ll do the rest of the activity throughout the class

General ledger

• An aggregation of all the accounts
• Shows all account balances
• Includes details of each account
• T-accounts sufficient for this course

Trial Balance

DR = CR for totals

Constructing the trial balance

Limits of the trial balance

• Can’t catch:
  • Unrecorded transactions
    • Because there’s no trace of them
  • Wrong amounts in balancing transactions in the journal
    • Everything still balances
  • Wrong accounts of the same type used in the journal
    • Everything still balances
    • \(A = L + E\) holds

What you can catch

• Let Out of balance amount be:
  • \(OOB = Assets - Liabilities - Equity\)
• If OOB / 2 is an integer
  • DR and CR in a transaction may be flipped
    • Ex.: Recorded a cash sale as a CR to cash and a DR to revenue
      • Should be a DR to cash and a CR to revenue
• If OOB / 9 is an integer
  • A slide error happened:
    • Ex.: Recorded 5,400 instead of 54,000
  • A Transposition error happened
    • Ex.: Recorded 45,000 instead of 54,000

T-accounts and the trial balance

1. Return to the in class activity
2. We’ll do the first three as a class
3. Finish the rest of the activity with your group
   • Do the two green tabs

Cash basis accounting

• Records cash only transactions
• Used by small companies
• \(Profit = Cash~in - Cash~out\)

PROBLEM

• This ignores underlying economic activity
  • If we make a sale on credit, that doesn’t add to profit
  • If we purchase something on credit, this doesn’t lower profit

Accrual accounting

• Records impact of transactions as they occur
• Required per IAS1, “Presentation of Financial Statements”
• Revenue recorded when it is “more likely than not”
• Expenses recorded as incurred
• Profit = Revenue - Expenses

PROBLEM

• Profit may not be indicative of cashflows
  • This is a concern for lenders
    • If there’s no cash, profit doesn’t matter, as the company will go bankrupt

Accrual transaction examples

Periodicity

Don’t focus on this too much for this class

Revenue recognition principal

• Recognize revenue in the period it was earned
  • May not be when cash is received
• Goods revenue recorded when it is more likely than not
• Service revenue recorded at the percentage complete
  • If 50% of the work is finished, record 50% of the revenue
  • If 20% of the work is finished, record 20% of the revenue

This will lead to a lot of tricky accounting, but mostly around period ends

Recognizing revenue

• Record revenue when:
  • Revenue can be measured reliably
  • Economic benefits are more likely than not
• For goods, you also need:
  • Transferred significant risks to buyer
    • If we are shipping [FOB destination], wait until received
    • If they handle shipping [FOB shipping point], wait until picked up for delivery
  • No continuing managerial involvement (to an extent)
  • Costs incurred from transaction can be measured reliably
• For services, you also need:
  • Stage of completion can be measured reliably
  • Cost incurred to date and costs to finish can be measured reliably

Matching principal

• Match expenses to the revenue within a period

1. Identify what expenses were incurred
2. Measure them
3. Match to the revenues

Expense recognition

• Recognize expenses only when an asset is used
  • Asset purchase \(\ne\) expense
• Formally, expenses are recognized when:
  1. Obligations are incurred, such as on receipt of goods or services have been received
  2. Obligations are offset against recognized revenues (matching principle)

Expense matching

When should we record…

1. A sale we are shipping at our expense
2. A sale we are shipping at the buyer’s expense
3. Revenue for a week long consulting project paid for up front
4. Electricity usage
5. Building usage (our building)
6. Sale of inventory for revenue

When should we record…

1. A sale we are shipping at our expense
   • Once the product reaches the buyer
2. A sale we are shipping at the buyer’s expense
   • Once we ship the product
3. Revenue for a week long consulting project paid for up front
   • Once the project is finished
4. Electricity usage
   • When billed or at period end (matching principle)
5. Building usage (our building)
   • At period end (matching principle)
6. Sale of inventory for revenue
   • At the time the revenue is recognized

Why do we need to adjust?

• The matching principle
  • Everything needs to match at period end
• All day-to-day accounts are ok as is
• Do before balance sheet and income statement
  • Adjustments will go to the trial balance
• Why not do this continuously?
  • Too costly – some accounts continuously change
  • Investors only see period-end statements anyway

We’ll only do this at period end

What do we need to adjust?

Adjusting entry types

• Deferral
  • Adjust for prepaid expense (some used)
  • Adjust for unearned revenue (some may be earned)
• Depreciation
  • Some long term assets have been used up
• Accrual
  • Record an expense in advance

Deferral

• Adjustment for cash paid or received in advance
  • Expense or revenue has yet to occur
  • We defer some of it to the next period

Depreciation

• Adjustment for allocating the cost of Property, Plant and Equipment (PP&E) over its useful life
• Record to accumulated depreciation
• Asset’s book value is asset account minus accumulated depreciation
• Depreciate to salvage value
  • What you expect to get when it is used up

Depreciation methods

Accrual

• Accrued expense: debit expense, credit liability

• Accrued revenue: debit asset, credit revenue

Overall effects

Adjusting entries

1. Return to the in class activity
2. 3 adjusting entries to add in
3. Do the three yellow tabs

Closing the books

• Reset all temporary accounts to 0
  • All revenues
  • All expenses
  • Dividends
• Credit temporary accounts that have a debit balance
  • Expenses, losses
• Debit temporary accounts that have a credit balance
  • Revenues, gains
• Helps to track income through each period
  • Since all income-related accounts start each period with 0 balance

Reset temporary accounts at period end

• We close the accounts into retained earnings directly
  • Or close into income summary, and then close that into retained earnings
• Debit Revenue, Credit Retained earnings
• Debit Retained earnings, Credit Expense
• Debit Retained earnings, Credit Dividends

Closing entry

1. Return to the in class activity
2. 1 closing entry to add in
3. Do the two red tabs

For next week

1. Recap the reading for this week
2. Read the pages for next week
   • Capital Structure (Chapter 10)
   • Accounting Statements (Chapter 3, Part B)
3. Homework to turn in next week
   • Available on eLearn
   • Submit on eLearn
4. Practice on eLearn
   • Practice on journal entries
   • Automatic feedback provided