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Financials Example
Throughout this example, we will examine the processes of journalizing, posting, and creating financial statements. We will work through a sample problem from start to finish in order to illustrate fully the methods of accounting.
Law Firm, owned by John Smith
During the month of December 1996, his firm underwent the following transactions:
December
1. Smith invested $6500 cash into his company.
2. The firm purchased $100 worth of office supplies in cash.
3. The firm purchased $7000 worth of office equipment that will be good for the next 70 months, with no salvage value.
4. The firm purchased $3000 worth of books for the law library on account that will be good for the next 30 months, with no salvage value.
5. The firm paid a premium of $1200 for insurance that covers the next two years.
6. The firm paid off $500 of the accounts payable.
7. The firm agreed to consult ABC Co. for the next 5 months, for $400 per month. The firm was paid $2000 up front.
8. Smith withdrew $1000 for his personal use.
9. The firm did a job and was paid immediately in cash, $4000.
10. The firm paid $1000 in salaries.
11. The firm paid $1000 in rent.
12. The firm paid $200 for utilities for the month.
The transactions above were journalized in Table 1. They were then entered into the ledger (Table 2) and an unadjusted trial balance was created. (Table 3).
Several transactions then occurred that needed to be accounted for (adjustments necessary).
Dec. 31
A. One month of the insurance policy had expired.
B. Work was done by the firm for which the firm was paid $400 on account.
C. The firm did 1 month of consulting work for ABC Co.
D. The firm used $50 in office supplies.
E. The firm incurred $350 in salaries payable.
F. Law Library subject to amortization of 1 month.
G. Office Equipment subject to amortization of 1 month.
As a result of the transactions made above, several adjustments must be made to the unadjusted trial balance. They are as follows:
A. Since 1 month of the insurance policy has expired, we must account for it. We know that the entire policy is good for 12 months (1 year); so 1 month is 1/12 of that time. The premium cost us $1200 in total, so 1/12 * $1200 = $100. Therefore, $100 of our insurance policy expired in December. We must take that $100 off the asset "prepaid insurance". We also must add $100 to insurance expense, to record the price of insurance for the month.
B. This is simply a case where we would note the work done as fees earned for $400. We were paid on account, so we must debit our accounts receivable for $400 as well.
C. By doing 1 month of consulting work, we earned 1 month of our unearned revenues to date. Since we had 5 months to account for, we have now worked 1/5 of the total period. This means that we have earned 1/5 of $2000, or $400. To record this, we simply credit earned fees for $400 and debit unearned fees for the same amount.
D. By using up $50 in office supplies, we have only $50 left. Therefore, our office supplies account must be credited for $50, and we must debit our office supplies expense account for the same.
E. During the period, we incurred $350 in salaries payable. We account for this by debiting the salary expense account for $350 and crediting the salaries payable account for $350 also.
F. The law library is subject to amortization for one month. Since we stated that this asset would be good for 30 months with no salvage value and that the total asset was worth $3000, we must expense $100 ($3000/30) for amortization for this month. So, we debit that account and credit our accumulated amortization account for the law library.
G. The office equipment is subject to amortization for one month. Since we stated that this asset would be good for 70 months with no salvage value and that the total asset was worth $7000, we must expense $100 ($7000/70) for amortization for this month. So, we debit that account and credit our accumulated amortization account for the office supplies.
Each of the above adjustments is displayed in the adjustments column of Table 3. Notice that in the situations where we had not yet used an account, we were forced to create one. For example, in B above, we needed to create an accounts receivable account to record the sales transaction.
Once the adjustments are completed, an adjusted trial balance can be created. (See Table 3)
From the adjusted trial balance, we can create the income statement, the statement of changes in owner's equity, and the balance sheet. Each of these is explained in detail in the section titled "Financial Statements". This example, however, displays the numbers that would be used to construct the financial statements in Table 3.