Hello, I'm Professor Brian Bushee. Welcome back. Starting with this video, we're gonna look at an extended case study, which 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 gonna 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 review. So we've seen in the last couple videos how journal entries and T-accounts can be used to track and record the effect of transactions. And the key is to make sure that our debits equal our credits when we record these journal entries. And if we do so, then 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 gonna 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 this types of accounts and credits will increase them. We set liabilities, shareholders equity and revenues to have credit balances so that credits will increase these accounts and debits 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 the decrease the various types of accounts and talked about how you should print this out, 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. >> Woo hoo. 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 its first set of transactions all the way through its 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 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 again through the whole life of the business. We're gonna 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 of 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 as $77,500. She realized she could set up a profitable business that rented out portable metal detectors to 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 markup 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 his heavy course load, Girard agreed to invest as a silent partner and allow Park to run the business, which she named Relic Spotter Inc. So now what we're gonna 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 increase in contributed capital which is stockholder's equity. But remember that we have to split this into two parts, the par value and the additional Paid-in-capital. So first we have common stock at par, which is going up by 25,000 shares times $1 or $25,000. We make stockholders equity go up with a credit, 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 that 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 gonna 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 2, Lacking the funds for her initial investment, Park borrowed the $50,000 from the Imperial Bank of Philadelphia on April 1, 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 loan. Personal loan does not show up in the Relic Spotter books. Now, having said that, this is the only time we're gonna 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 on behalf of the company, so you're not gonna 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 3. On April 2nd, 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 to debit or credit cash based on whether you receive or pay cash. So in this case we're paying $3,900 in cash for legal fees, which seems quite exorbitant. But I guess it's a lawyer, so what are you gonna 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 a debit. So what are we getting for this cash? We're not really getting an asset, this is more of just the cost of doing business. So it's going to be legal fee's expense. Remember that expenses can increase through debits, so we're going to debit legal fee expense, which will increase expenses and reduce stock holder's 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-account, so we bring back our cash T-account. We put 3,900 on the credit side, or the right hand side with a little 3 to indicate that it's transaction number 3. And we create a T-account for legal fee expense with 3900 on the debit side or the left side. Next transaction, number 4. To house the business, Park bought an abandoned pizza parlor near Fairmont Park for $155,000 on April 7. The building was old and needed renovation work. The purchase documents allocated $103,000 to 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. Wow, 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. Cash is an asset, assets go down with a credit, so we credit cash for 31,000. We acquired land and building. Land and building are both assets, assets go up with a debit, so we wanna 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 a 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? >> Huh? Those two look like twins. Anyway, both good questions. We keep land and building in separate accounts, because later on we're gonna 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 own 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 an interest payable. We've got a lot of posting to do for this journal entry. We bring back our cash T-account and put 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 to 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 25, at which time she paid in cash the amount owed for the renovations. For this transaction, the first thing we're gonna do is ignore the stuff about salvage value and 25 years. We'll come back to that in a later video. Instead, we're gonna 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 a credit, so we credit cash for 33,000. So now we're looking for a 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. Oh bother. >> Great question. The general rule is if you spend money on maintenance, an expected cost on maintaining the asset, then you would expense it. But if you spend spend money 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 balance in cash is, 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 phoned a number of metal detector vendors until she found one that was willing to give her volume discount. On June 2nd, Park purchased 240 metal detectors at an average cost of $500 per unit, so that's $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 gonna again ignore the two years, no remaining value will come back to that in a later video. We need to record the transaction where we paid $120,000 cash to 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're 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 account for goods that we buy with the intention of selling as quickly as possible at a markup. We don't call the 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. Then we post this to T-accounts, we add another credit on the right had side of cash. Good thing we raised $250,000, because we're spending it pretty quickly. And we create a T-ccount 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!