Hello, I'm Professor Brian Bouche. Welcome back. Starting with this video we're going to look at an extended case study with will illustrate the accounting cycle. The accounting cycle is all the steps that you have to follow to go from recording transactions all the way through preparing financial statements. The case is going to be spread out over a number of videos, interspersed with new topics that we introduce, which will then illustrate in the case study. Let's get started. >> Let's start off with a quick reviews. So, we've seen in the last couple of videos how journal entries and T accounts can be used to track and record the effects of transactions. And the key is to make sure that debit equal our credits when we record these journal entries. If we do so, we know that the balance sheet equation will hold when we add everything up. So the debits and credits substitute for the balance sheet equation. We talked about how debit means left side entry and credit means right side entry. >> So, when I buy something at the store, and the cashier says debit or credit? Should I point out that he is really asking left or right? >> Please don't say that, you're going to get me in trouble. >> To make sure that debits and credits will preserve the balance sheet equation we set assets and expenses to have debit balances which means that debits will increase these types of accounts and credits will decrease them We set liabilities, share holders equity and revenues to have credit balances so that credits will increase these accounts and debts will decrease them. We also looked at a visual picture that we could use to remember this. The super T account which shows whether debits or credits increase or decrease the various type of accounts, and talked about how you should print this out to keep it handy until you memorize it or tattoo it on your arm, whatever your inclination may be. Now we're going to talk about the accounting cycle. >> Let's take a ride on the accounting cycle! >> It's not that kind of cycle but it should be just as fun. >> We're going to go through the entire accounting cycle with an extended case which follows a start up company from it's first set of transactions all the way through it's first set of financial statements. And that's what the accounting cycle is set up to do. First, as the business is operating during a fiscal period, transactions happen. And then you have to analyze those transactions to figure out how to come up with journal entries, and then post those journal entries to T accounts. Once the period is over, we do something called an unadjusted trial balance to make sure that we haven't made any math mistakes or transposed any numbers. Then we do something called adjusting entries, which are needed to get the books correct before we do financial statements. After another trial balance we prepare the financial statements. When we're done with those we have to do something called closing entries which gets us all set to start the new period, so that we can do this over and over and over and over and over and over again through the whole life of the business. We're going to start the case with the first part of the accounting cycle where we analyze transactions. And then figure out how to journalize them, which is record each transaction as a journal entry in something called the general journal. Then we're going to post that journal entry to T accounts, or general ledger, where we'll keep a running total of the balance in all the accounts. So now let's take a look at the facts of the case. In March 2012, Rebecca Park identified an excellent business opportunity while she was a first year MBA student at Wharton. She read a story about an MBA student who tripped while jogging in Fairmount Park and found an ancient gold coin in the underbrush. It was an old Viking coin that was appraised at $77,500. She realized she could set up a profitable business that rented out portable metal detectors two people that wanted to search Fairmount Park for more Viking relics. Also, Park had the idea of stocking her store with "sundries," such as water bottles and energy bars, that she could sell at a huge mark up to renters before their expedition into the park. Park prepared a business plan and approached a fellow student, Jay Girard, who had a sizable trust fund and who she believed would invest in this new venture. Due to his myriad of other investments, and its heavy course load, Girard agreed to invest as a silent partner and allow Park to run the business, which she named Relic Spotter Incorporated. So now what we're going to do is go through a number of transactions for the company. After each transaction is read, you should pause the video and try to do the journal entry. Think about what accounts are involved, do they increase or decrease, and then do we debit or credit? Then resume the video to see the answer and the explanation. And that's when we'll post the journal entry to T accounts. First transaction on April 1st, 2012, Girard decided to invest $200,000 and Park put up $50,000 to purchase a total of 25,000 shares in the new company. The par value of the shares was $1. In this transaction, we're receiving $250,000 of cash for issuing equity. Cash is increasing by $250,000. Cash is an asset. We increase assets through debits. So we're going to debit cash for $250,000 to increase this asset. We also have $250,000 in contributed capital which is stockholders equity. But remember we have to split this into two parts the par value and the additional capital. So first we have common stock at par, which is going up by 25,000 shares times $1 or $25,000. We make stockholder's equity go up with a credit, and so we credit common stock for 25,000 and then we credit additional paid in capital for the rest, $225,000. Which is the number we need so that our debits equal our credits. >> Excuse me, are you allowed to have more than one credit in a journal entry? >> Zee par value! Again?! >> Yes, you can have more than one credit and or more than one debit. As we talked about last time, the only requirement is that your debits equal your credits. And it looks like the par value guy is back again, and going to have to deal with par value a lot so get used to it. >> After we do the journal entry, we need to post these amounts to T accounts where we can keep a running total of the balance in each account. So we create a T account for cash. Put the 250,000 on the debit or left hand side. We put a little (1) there so that we can trace this number back to the original journal entry in the general journal. We create a similar T account for common stock of course, the balance is on the credit side. And the same thing for additional paid in capital. Transaction two, lacking the funds for her initial investment, Park borrowed the $50,000 from the Imperial Bank of Philadelphia on April 1st using her parent's house as collateral. The journal entry for this one is well, there is no journal entry. Because Rebecca Park is borrowing the money personally, it's not Relic Spotter that's borrowing the money. In other words, Relic Spotter doesn't have to pay this loan back, Rebecca Park does. So there's something called the entity concept which says the only thing that should go in a company's books are transactions for the company. Not transactions for the employees so we want to keep this separate. Rebecca Park's personal loan does not show up in the Relic Spotter books. Now having said that, this is the only time we're going to do this trick and the rest of the case I'll talk about Rebecca Park does this, Rebecca Park does that, but for the rest of the case she's doing things for on behalf of the company, so you're not going to see this trick again. Since there's no journal entry, there's nothing to post to T account, so we can go right on to transaction number 3. On April 2, Park hired a lawyer to have the business incorporated. Because this was a fairly simple organization, the legal fees were only $3,900. So let's take a look at the journal entry. I always recommend starting with cash, if there's cash involved in the transaction, because you'll quickly memorize whether you receive or pay cash. So in this case we're paying $3,900 of cash for legal fees which seems quite exorbitant but yeah, I guess, it's lawyer, so what you're going to do? Anyway, if we're paying cash, cash is going down. Cash is an asset so assets go down through credits. So we're going to credit cash for $3,900. Now, notice even though I started with cash and it was a credit, I don't write it first in the journal entry. As we talked about in a prior video, you always want to write debits first so I had to skip some space write the credit second and indent it. So, now we need to find debit. So, what are we getting for this cash? We're not really getting an asset this is more of just a cost of doing business. So, it's going to be legal fees expense. Remember that expenses get increased through debits, so we're going to debit legal fee expense, which will increase expenses and reduce stockholders equity by $3,900. >> Excuse me, why isn't this an asset? >> I guess you could say this is an asset because the future benefit is that we get to operate the business forever once we've incorporated it. It's a pretty lame rationale, but there were companies that used to call this an asset. Now the rules are explicit. This kind of expenditure has to be expensed immediately. Let's post this to T accounts, so we bring back our cash T account, we put $3,900 on the credit side or the right hand side with the little 3 to indicate that it's transaction number 3. And we create a T account for legal fee expense with $3,900 on the debit side or the left side. Next transaction, number four. To house the business, Park bought an abandoned pizza parlor near Fairmount Park for $155,000 on April 7. The building was old and needed renovation work. The purchase documents allocated $103,000 to the land and $52,000 to the building. Park paid for the building with $31,000 cash and a $124,000 mortgage from the Imperial Bank. This is a big transaction so it's going to require a big journal entry. Always like to start with cash if we can. We paid $31,000 of cash Cashes and asset. Assets go down with the credit so we credit cash with 31,000. We acquired land and building, land and building are both assets. Assets go up with a debit so we wanted debit building for $52,000 and debit land for $103,000 and make those two accounts go up. Now at this point, our debits don't equal our credits so we can't stop. We're missing one more piece, and that piece is the mortgage. A mortgage is a liability. Liabilities go up with the credit, so we need to credit mortgage payable for $124,000. And now our debits equal our credits. >> Why do we need to have separate accounts for land and for buildings? And why don't we record interest payable as well? Won't we have to pay interest on the mortgage? Those two look like twins. Anyway, both good question?. We keep land and building in separate accounts because later on we're going to do something called depreciation and these two accounts will be treated differently. As for the interest question, I think we talked about this in a prior video, but it's good to review it. We don't owe any interest when we take out the mortgage. We could pay back the mortgage immediately. And not have to pay any interest. Only as time passes and we owe interest without paying it, will we have to record interest payable. >> We've got a lot of posting to do for this journal entry. We bring back our cash T account and put in the another credit on the right hand side. Create T accounts for building and land, and one for Mortgage Payable. Transaction 5, Park felt that some renovation work would extend the life of the building for 25 years with an expected salvage value of $10,000. She ordered the renovation work,costing $33,000, to begin immediately. The work was completed on May 25th, at which time she paid in cash the amount owed for the renovations. For this transaction, the first thing we're going to do is ignore the stuff about salvage value in 25 years. We'll come back to that in a later video. Instead we're going to focus on the transaction that happened on May 25th, which is when Park paid the cash. We paid $33,000 of cash, cash is an asset. We make an asset go down through our credit, so we credit cash for $33,000. So now we're looking for our debit, what did we get for this cash? Well, we added to the building and so we're going to debit building for $33,000 to increase the balance in the building account. Remember we make assets go up through debits. >> Excuse me, why isn't this an expense instead of an asset? All of the expenses seem like assets to me. And the assets seem like expenses. Bother. >> Great question. The general rule is if you spend money on maintenance, an expected cost of maintaining the asset, then you would expense it. But if you spend for a capital improvement which would be something that would increase the value of the building or how long you plan to use it. Then you get to add that to the building account. But don't worry about this now, this is something we're going to talk about in a lot more detail later in the course. >> Then we post this to T accounts, we add another credit to the right hand side of the cash account, and a debit to the left hand side of the building account. So now the balance in the building is $85,000. I would tell you what the balancing cashes but I can't do math in my head, so you'd have to figure that out on your own. Next transaction, transaction number 6. Park found a number of metal detector vendors until she found one that was willing to give her volume discount. On June 2, Park purchased 240 metal detectors at an average cost of $500 per unit, so it $120,000 total. The innovation in the industry is so rapid that Park felt the units would only last for two years. At which time they would have no remaining value. In this transaction we're going to again ignore the two years, no remaining value. We'll come back to that in a later video. We need to record the transaction where we paid $120,000. Cash get metal detectors. If we're paying cash, cash is going down. Cash is an asset, goes down with a credit, so we credit cash for 120,000. What are we getting? What's the debit? Well we are getting metal detectors. Metal detectors are an asset. We make assets go up with a debit. So we debit metal detectors for $120,000. >> Wait, why aren't the Metal Detectors considered Inventory? >> Yeah, I thought any merchandise that a company purchases is called inventory. >> We only use the inventory accounts for goods that we buy with the intention of selling as quickly as possible out of markup. We don't call them metal-detectors inventory, because we intend to keep them for two years, and use them over and over and over and over again to generate rental revenues. So the metal detectors are more like a piece of equipment than what we would traditionally think of as inventory. >> [BLANK AUDIO] Then we post this to T accounts, we add another credit on the right hand side of cash. Good thing that we raised $250,000 dollars because we're spending it pretty quickly and, we create a T account for metal detectors which now has a debit balance as an asset. So we're about halfway done at this point so why don't we go ahead and stop this video. And we'll pick up the case in the next video with the next transaction. I'll see you then. >> Excuse me, see you next video.
