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C H A P T E R
Preparing Financial
Statements
C H A P T E R
Preparing Financial
Statements
F
OBJECTIVES
After reading 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, posting, transactions, debit and credit, trial balance, and adjusting entries, and 3. Prepare financial statements from a list of transactions.
inancial management is based on proper use and interpretation of financial state- ments. This chapter will present a brief overview of the accounting involved in prepar- ing financial statements. Students interested in a more comprehensive coverage should refer to one of the financial accounting texts listed at the end of the chapter. The preparation of financial statements begins with analysis of transactions. Transactions are broadly defined as events that have an economic impact on the busi- ness. Examples include sale of merchandise, purchase of inventory, and paying of salaries and utilities. Because a typical business will experience thousands of transac- tions in a year, a system is needed to track them. The system most commonly used con- sists of a general journal and a ledger of accounts. The basic component of this system is the account. There is a separate account for every asset, liability, owner equity, revenue, and expense that appears on the financial statements. For example, there are cash accounts, accounts payable accounts, retained earnings accounts, cash sales accounts, credit sales accounts, rent expense accounts, and salary expense accounts. The account is simply a central place used to collect rel- evant information about all transactions that affect a particular item on the financial statements. For example, all transactions that affect cash would be recorded in the cash account. Accounts may be kept in several physical forms. Early on, they were kept
24 Financial Management for Pharmacists
as pages in a loose-leaf folder or notebook. More recently, accounts have been kept as computer files. Accounts are kept in a ledger of accounts. They appear in the ledger in the same order that they appear on the financial statements, as follows—current assets, noncurrent assets, current liabilities, noncurrent liabilities, owners’ equity, revenues, and expenses. The general journal is a chronologic listing of transactions. As transactions occur, they are journalized , or recorded in the journal. Later, they are posted to the proper accounts in the ledger. In recording transactions, businesses need a system that ensures that assets always equal the sum of liabilities and owners’ equity and that can be used to detect and min- imize errors. The system used is called the system of debits and credits.
DEBITS AND CREDITS
Every account has two sides: left and right. The left side (or column) is referred to as the debit side and the right side (or column) as the credit side. (For purposes of instruc- tion, we will use “T-accounts” such as shown in Figure 3-1. Businesses typically use “balance column accounts” such as shown in Figure 3-2. Both are used in the same manner—only the physical appearance of the account is different.) The following rules govern the recording of transactions in the debit and credit system: (^) 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 owners’ equity is a credit and is recorded on the right side of the liability or owners’ 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 owners’ equity is a debit and is recorded on the left side of the liability or owners’ equity account. (^) Because an expense decreases owners’ equity, it is a debit and is recorded on the left side of the expense account. (^) Because a revenue increases owners’ equity, it is a credit and is recorded on the right side of the revenue account. Four basic rules govern the recording of transactions:
1. Each transaction must be recorded separately. 2. The transaction must be recorded so that ASSETS LIABILITIES OWNERS’ EQUITY. For example, if the transaction includes an increase in an asset, it must
Accounts Receivable 425 250 150 125
200
FIGURE 3–1 T-account.
26 Financial Management for Pharmacists
Note the following practices that are used in journalizing entries:
1. Each entry is dated. 2. The debit is entered first. 3. Credits are entered last and are indented. 4. There is a short note explaining the transaction. 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 $200 in 30 days.
6-23-X0 Cash 300 Accounts receivable 200 Revenues 500 Record revenues from services provided to Glow Years Retirement Home
6-28-X0 P. Dill, Withdrawals 100 Cash 100 Record owner withdrawal of $
6-29-X0 Rent expense 100 Cash 100 Record payment of June rent
6-30-X0 Phone expense 25 Accounts payable 25 Record phone expense for June
All $500 is recorded as a revenue on the date that services were provided. This is true in the accrual system, even though full payment has not yet been received. In this par- ticular transaction, more than two accounts are affected. On June 28, Dill withdraws $100 in cash from the business for personal use.
On June 29, the rent of $100 is paid.
On June 30, a $25 phone bill is received. The bill will not be paid until July 15.
At this point, all transactions for the month have been journalized. The journal page, as it would appear at the end of the month, is shown in Figure 3-3. The next step is to post the transactions to the ledger of accounts.
CHAPTER 3 ^ Preparing Financial Statements 27
POSTING TO THE LEDGER OF ACCOUNTS
Transactions are typically journalized soon after they occur. They are posted after some longer period of time. For example, they may be journalized daily and posted weekly or monthly. This section explains how the transactions for PD Consulting Service for the month of June would be posted to the ledger. The first transaction (June 1) involves $1,000 increases in cash and capital. Thus, the cash account would be debited $1,000. The entry is recorded as $1,000 on the left side of the cash account. Next, the $1,000 increase in capital is recorded on the right side of the P. Dill, Capital account. These entries are shown below:
Ledger of Accounts Cash P. Dill, Capital 1,000 1,
Journal
P. Dill, Consultant Pharmacist Services
Date Account Title and Explanation Dr. Cr. 6-1-X0 Cash 1, P. Dill, Capital 1, Record owner investment in business
6-23-X0 Cash 300 Accounts receivable 200 Revenues 500 Record revenues from services provided to Glow Years Retirement Home
6-28-X0 P. Dill, Withdrawals 100 Cash 100 Record owner withdrawal of $
6-29-X0 Rent expense 100 Cash 100 Record payment of June rent
6-30-X0 Phone expense 25 Accounts payable 25 Record phone expense for june
FIGURE 3–3 Journal for PD Consulting Service.
The remaining entries are posted in a similar manner. The ledger of accounts for PD Consulting Service after posting is shown in Figure 3-4.
CHAPTER 3 ^ Preparing Financial Statements 29
PD Consulting Service
Trial Balance
June 30, 20X
Account Name Debit Credit Cash $1, Accounts receivable 200 Accounts payable 25 P. Dill, capital 1, P. Dill, withdrawal 100 Consulting revenue 500 Rent expense 100 Phone expense 25
Totals $1,525 $1,
FIGURE 3–5 Trial balance for PD Consulting Service.
PD Consulting Service
Income Statement
For the Month Ended June 30, 20X
Consulting revenue $ Expenses Rent $ Phone 25 Totals expenses 125
Net income $
FIGURE 3–6 Income statement for PD Consulting Service.
PD Consulting Service
Statement of Capital
For the Month Ended June 30, 20X
Capital, P. Dill, June 1, 20X0 $1, Add: Net income 375 Less: P. Dill, withdrawal 100
Capital, P. Dill, June 30, 20X0 $1,
FIGURE 3–7 Statement of capital for PD Consulting Service.
At the end of 19X0 an adjusting entry must be made to recognize that the com- puter has been used for 1 year and, consequently, that some expense for use of the computer has been incurred. The adjusting entry required is shown.
30 Financial Management for Pharmacists
PD Consulting Service
Balance Sheet
June 30, 20X
Assets Cash $1, Accounts receivable 200 Total assets $1,
Liabilities Accounts payable $ 25 Total liabilities $ 25
Owner’s equity P. Dill, capital $1,
Total liabilities plus owner’s equity $1,
FIGURE 3–8 Balance sheet for PD Consulting Service.
1-1-X0 Computer 3, Cash 3, Record purchase of computer
ADJUSTING ENTRIES
Financial statements must be prepared at the end of each accounting period (which is generally the end of each fiscal year). Some transactions begin in 1 year and are not concluded until a later one. This causes problems in accurately matching expenses and revenues in the proper year. Recall that revenues are recognized in the year in which the sale is made, and that all expenses required to generate revenues are recognized in the same year as the associated revenues. If a transaction begins in 1 year and is not con- cluded 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. For example, a pharmacy may purchase a computer and use it over a 3-year period. Because the computer is used to generate revenues in each of 3 years, part of its cost must be recognized as an expense in each of those years. To do this, the accountant must make an adjusting entry at the end of each year. The following journal entries record the purchase and depreciation of the computer, which was purchased for $3,000, was expected to last 3 years, and was expected to have no residual value. The first entry records the purchase of the computer. This is not an adjusting entry.
32 Financial Management for Pharmacists
2. An entry to close each of the expense accounts and transfer their balances to the ISA 3. An entry to close the ISA and transfer its balance to the owners’ equity account—either capital (for a sole proprietorship) or retained earnings (for a corporation) 4. An entry to close the owner withdrawal account (of a sole proprietorship) or the dividends paid account (of a corporation) and transfer the balance to the capital account Closing entries are dated as of the last day of the accounting period. They are jour- nalized and then posted to the ledger. Closing entries are made after all other entries have been recorded. The 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 balances in each of the income statement accounts so they are ready for use in the next accounting period.
EXAMPLE PROBLEM: PD CONSULTING SERVICE CONTINUED
Figure 3-9 shows the year-end ledger of accounts for PD Consulting Service before closing. The balance in each account and the account name are listed to prepare the trial balance shown in Figure 3-10. The trial balance is then used to prepare the finan- cial statements shown in Figures 3-11 through 3-13.
PD Consulting Service Ledger of Accounts
Cash P. Dill, Capital Rent Expense 950 1,000 1,
Accounts Receivable P. Dill, Withdrawals Phone Expense 1,100 500 300
Accounts Payable Consulting Revenue Salary Expense 500 14,500 12,
FIGURE 3–9 Year-end ledger of accounts for PD Consulting Service before closing entries are
posted.
CHAPTER 3 ^ Preparing Financial Statements 33
PD Consulting Service
Trial Balance
May 31, 20X
Account Name Debit Credit Cash $ 950 Accounts receivable 1, Accounts payable 550 P. Dill, capital 1, P. Dill, withdrawal 500 Consulting revenue 14, Rent expense 1, Phone expense 300 Salary expense 12,
Totals $16,050 16,
FIGURE 3–10 Trial balance for PD Consulting Service.
PD Consulting Service
Income Statement
Year Ended May 31, 20X
Consulting revenue $14, Expenses Rent $ 1, Phone 300 Salary 12, Total 13, Net income $ 1,
FIGURE 3–11 Income statement for PD Consulting Service.
PD Consulting Service
Statement of Capital
For the Year Ended May 31, 20X
Capital, P. Dill, June 1, 20X1 $1, Add: Net income 1, Less: P. Dill, withdrawal 500 Capital, P. Dill, May 31, 20X1 $1,
FIGURE 3–12 Statement of capital for PD Consulting Service.
CHAPTER 3 ^ Preparing Financial Statements 35
Figure 3-14 shows the entries necessary to close PD Consulting Service’s tempo- rary accounts. Figure 3-15 shows the balances in the income summary, capital, and withdrawal accounts after each closing entry is made. As indicated, the first closing entry closes the consulting revenue account to the ISA. As shown in Figure 3-15, this results in a $14,500 credit balance in the ISA. It also results in a zero balance in the consulting revenue account. The second closing entry closes the expense accounts and transfers their balances to ISA. In our example, this adds a $13,500 debit to the ISA and results in zero balances in each of the expense accounts. The ISA is then closed to the capital account. This is done by means of a $1,000 debit to the ISA and a $1,000 credit to the P. Dill, Capital account. At this point, the ISA has a zero balance and the P. Dill, Capital account has a $2,000 credit balance. The last entry closes the owner withdrawal account to capital. This results in a $500 debit to P. Dill, Capital and a final balance of $1,500 in the P. Dill, Capital account. This is the same figure calcu- lated on the capital statement (Fig. 3-12) and listed on the balance sheet (Fig. 3-13).
Balance after consulting revenue is closed to ISA:
Income Summary Account P. Dill, Capital 14,500 1,
Balance after expense accounts are closed to ISA:
Income Summary Account P. Dill, Capital 13,500 14,500 1,
Balance after ISA is closed to capital account:
Income Summary Account P. Dill, Capital 13,500 14,500 1, 1,000 1, 0
Balance after withdrawal account is closed to capital:
P. Dill, Withdrawal P. Dill, Capital 500 500 1, 0 1, 500 1,
FIGURE 3–15 Balance in income summary account and capital amount after each closing entry.
Figure 3-16 shows the ledger after closing. The balances for the asset and liability accounts remain, the capital account reflects the changes from net income and owner withdrawal, and the balances in the revenue and expense accounts are now set to zero.
Suggested Readings
Anthony RN, Breitner LK. Essentials of Accounting. 8th Ed. Upper Saddle River, NJ: Prentice Hall, 2003. Anthony RN, Breitner LK. Essentials of Accounting and Post Test Booklet 8. 8th Ed. Upper Saddle River, NJ: Prentice Hall, 2003. Warren CS, Reeve JM, Fess PE. Accounting. 21st Ed. Mason, OH: Thomson Southwestern, 2005. Warren CS, Reeve JM, Fess PE. Financial Accounting. 9th Ed. Mason, OH: Thomson Southwestern, 2005.
QUESTIONS AND PROBLEMS
1. Indicate whether each of the following would be a debit or a credit. a. Cash increases by $1, b. Accounts payable increase by $1, c. Owners’ equity increases by $ d. Rent expense of $ e. Revenue of $ f. Accounts receivable decrease by $ g. Notes payable increase by $ h. Owner withdrawal of $ i. Fixed assets increase by $ j. Inventory increases by $
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PD Consulting Service Ledger of Accounts
Cash P. Dill, Capital Rent Expense 950 1,
Accounts Receivable P. Dill, Withdrawals Phone Expense 1,
Accounts Payable Consulting Revenue Salary Expense 550
FIGURE 3–16 Ledger of accounts for PD Consulting Service after closing.
4. Assume Piedmont Pharmacy’s fiscal year ends on December 31. Which of the following would require adjusting entries? Explain your answers. a. Rent for November was paid the following December. b. Rent for December was paid the following January. c. Salary expense of $5,000 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 week 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 computer was borrowed from a bank on a 5-year loan. Both principal and interest are due in 5 years. 5. For what period of time is transaction data collected in an income statement account? In a balance sheet account? 6. Which of the following accounts must be closed at the end of an accounting period? a. Cash b. Accounts receivable c. Sales d. Rent expense e. Owner withdrawal f. Consulting revenues 7. A year-end trial balance for New Service Company is shown. From this balance, pre- pare financial statements and necessary closing entries for New Service Company.
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Trial Balance
New Service Company
December 31, 20X
Account Name Debit Credit Cash 4, Accounts receivable 17, Supplies 3, Equipment 40, Accumulated depreciation: equipment 4, Accounts payable 9, Note payable 10, Accrued interest payable 375 J. Smith, Capital 39, Consulting revenue 60, Salary expense 46, Utility expense 1, Misc. expense 1, Depreciation expense 4, Supplies expense 5, Interest expense 375 Totals 122,375 122,
8. On August 1, 20X5, Linda Smith established a nursing home pharmacy consult- ing business named Long-Term Care Consultants. The business had the following transactions during the month: a. On August 1, Smith invested $1,000 in the business. b. On August 3, she purchased $100 of supplies with cash. c. On August 5, she purchased $500 of office furniture on account. d. On August 7, she provided services to the Golden Agers Home. She billed them for $250, which they agreed to pay in 30 days. e. On August 10, she provided services to the Old Sailors Home. She billed them for $400, which they paid. f. On August 18, she paid rent of $250 with cash. g. On August 25, she withdrew $100 cash for personal use. h. On August 28, she received and paid a utilities bill for $50. i. On August 30, she paid $100 on account for the previously purchased furniture.
Smith’s accountant has set up the following accounts for use by the business:
CHAPTER 3 ^ Preparing Financial Statements 39
Cash L. Smith, Withdrawals
Accounts receivable Consulting Fees
Supplies Rent expense
Furniture Utilities expense
Accounts payable L. Smith, Capital
Record these transactions, post them to the ledger of accounts, and prepare a trial balance, income statement, balance sheet, and a statement of capital for August.
