2-1

Ch.2 A Review of the Accounting Cycle

1. Basic steps in the accounting process

(accounting cycle)

2. Analyze transactions and make and post journal

entries

3. Make adjusting entries, produce financial

statements, and close nominal accounts

4. Distinguish between accrual and cash-basis

accounting

5. Discuss the importance and expanding role of

computers to the accounting process

2-2

1. Basic Steps in the Accounting Process

1. Business documents are analyzed.

2. Transactions are recorded.

3. Transactions are posted.

(continued)

The Recording Phase The Recording Phase

2-3

7. Nominal accounts are closed.

8. A post-closing trial balance may be

prepared.

The Accounting Process

4. A trial balance of the accounts in the

general ledger is prepared.

5. Adjusting entries are recorded.

6. Financial statements are prepared.

The Reporting Phase The Reporting Phase

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2-5

• Transactions are events that transfer or

change goods or services between or

among two or more entities.

• Business documents, such as invoices,

provide evidence that transactions have

occurred as well as the data required to

record the transactions in the accounting

records.

Accounting Terminology

2. Analyze Transactions and Make and Post

Journal Entries

2-6

• Double-entry accounting is an old and

universally accepted system for recording

accounting data.

• Each transaction is recorded in a way that

maintains the equality of the basic accounting

equation:

Assets = Liabilities + Owners’ Equity

(continued)

Accounting Terminology

2-7

• A debit is an entry on the left side of an

account.

• Assets, expenses, and dividends are

increased by debits and decreased by

credits.

• A credit is an entry on the right side of

an account.

• Liabilities, capital stock, retained

earnings, and revenues are increased by

credits and decreased by debits.

Accounting Terminology

2-8

Three-Step Journal Entry Process

1. Identify the accounts involved with an

event or transaction.

2. Determine whether each account

increased or decreased (this information,

coupled with the answer to step 1, will tell

you if the account was debited or

credited).

3. Determine the amount by which each

account was affected.

2-9 2-9

2-10 2-10

(continued)

2-11 2-11

2-12

Summarizing

1. Assets are increased by debits and decreased by credits.

2. Liability and owners’ equity accounts are increased by credits and decreased by debits.

3. Owners’ equity for a corporation includes capital stock accounts and the retained earnings account.

4. Revenues, expenses, and dividends relate to owners’ equity through the retained earnings account.

(continued)

2-13

5. Expenses and dividends are increased by debits and decreased by credits because they reduce owners’ equity.

6. Revenues are increased by credits and decreased by debits.

7. The difference between total revenues and total expenses for a period is net income (loss), which increases (decreases) owners’ equity through the retained earnings account.

Summarizing

2-14

Analyzing Business Documents

• The business document provides support for the data to be recorded in the journals.

• Documents underlying each recorded transaction provide a means of verifying the accounting records and thus form a vital part of the information and control systems.

• Normally, a business document, or source

document, is the first record of each

transaction.

2-15

Journalizing Transactions

• The general journal is used to record all transactions for which a special journal is not maintained.

• A special journal is used to record a

particular type of frequently recurring

transaction.

• Once the information provided on business documents has been analyzed, transactions are recorded in chronological order in the appropriate journal or journals.

2-16

Journalizing Transactions

2-17

• An account is used to summarize the

effects of transactions on each element

of the expanded accounting equation.

• A ledger is a collection of accounts

maintained by a business.

• The transfer of information from the

journal to the appropriate accounts in the

ledger is referred to as posting.

Posting to the Ledger Accounts

(continued)

2-18

Posting to the Ledger Accounts

2-19

• The general ledger includes all accounts

appearing on the financial statements, and

separate subsidiary ledgers afford

additional detail in support of certain general

ledger accounts.

• The general ledger account that

summarizes the detailed information in a

subsidiary ledger is known as a control

account.

Establishing Separate Ledgers

2-20

Preparing a Trial Balance

• After all transactions for the period have

been posted to the ledger accounts, the

balance for each account is determined.

• A trial balance is a list of all accounts

and their balances.

• It provides a means to assure that total

debits equal total credits.

(continued)

3. Make Adjusting Entries, Produce

Financial Statements, and Close Nominal

Accounts

2-21 (continued) 2-21

2-22 2-22

2-23

Preparing Adjusting Entries

• Although the majority of accounts are up to date

at the end of the accounting period and their

balances can be included in the financial

statements, some accounts require adjustment

to reflect current circumstances.

• At the end of each accounting period, in order to

report all asset, liability, and owners’ equity

amounts properly and to recognize all revenues

and expenses for the period on an accrual basis,

accountants are required to make adjusting

entries prior to preparing financial statements.

2-24

Steps to Analyze Circumstances

1. Determine whether the amounts

recorded for all asset and liabilities is

correct.

2. Determine what revenue or expense

adjustments are required as a result of

the changes in recorded amounts of

assets and liabilities indicated in step 1.

2-25

1. Unrecorded assets—Assets and revenues

that have been earned but not yet recorded.

2. Unrecorded liabilities—Expenses and

liabilities that have been incurred but not yet

recorded.

Areas Most Commonly Requiring Analysis

Transactions where cash will be exchanged in a

future period:

(continued)

3. Prepaid expenses—Expenses that have been recorded but not yet incurred.

4. Unearned revenues—Revenues that have been recorded but not yet earned.

2-26

Rosi, Inc.

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2-27

• Revenues should be recorded when earned, regardless of when cash is received.

• This ensure that all receivables are properly reported on the balance sheet in the correct amounts.

• The unrecorded receivables are earned and represent amounts that are receivable in the future.

(continued)

Unrecorded Assets

2-28

(a) If revenue is earned but not yet collected

in cash, a receivable exists. Rosi, Inc.,

has interest on a note receivable of $250.

Unrecorded Assets

Interest Receivable 250

Interest Revenue 250

To record accrued interest

on notes receivable.

2-29

• Liabilities can be created by expenses

being incurred prior to being paid or

recorded.

• Adjusting entries are required at the end of

the accounting period to recognize any

unrecorded liabilities.

Unrecorded Liabilities

(continued)

2-30

(b) Rosi, Inc., had unrecorded salaries and

wages amounting to $2,150 at the end of

the accounting period.

(continued)

Unrecorded Liabilities

Salaries and Wages Expense 2,150

Salaries and Wages Payable 2,150

To record accrued salaries

and wages.

2-31

(c) Rosi, Inc., firm accrued interest of $5,000

on a bond payable.

(continued)

Unrecorded Liabilities

Interest Expense 5,000

Interest Payable 5,000

To record accrued interest

on bonds.

(d) Rosi, Inc., owed federal and state

income taxes totaling $8,000.

Income Tax Expense 8,000

Income Taxes Payable 8,000

To record income taxes.

2-32

• Payments that a company makes in

advance for items normally charged to

expense are known as prepaid expenses.

• An expense is the using up of an asset.

• The adjusting entry shows the complete

consumption of an asset.

Prepaid Expenses

2-33

Prepaid Expenses Originally Debited to an

Asset Account

If the asset account was originally debited, the

adjusting entry requires that an expense account

be debited for the amount applicable to the

current period and the asset account credited.

(continued)

(e) The expired portion of Rosi Inc.’s prepaid

insurance is $4,200. The following

adjusting entry is required:

Insurance Expense 4,200

Prepaid Insurance 4,200

To record expired insurance

($8,000 – $3,800 = $4,200).

2-34

If an expense account was originally debited, the

adjusting entry requires that an asset account be

debited for the amount applicable to future

periods and the expense account be credited.

(continued)

Prepaid Expenses Originally Debited to an

Expense Account

If Rosi’ Inc., had originally debited Insurance

Expense for $8,000, the expense account shows

$8,000, but $3,800 is applicable to future periods.

The adjusting entry would be as follows: Prepaid Insurance 3,800

Insurance Expense 3,800

To record prepaid insurance

($8,000 – $4,200 = $3,800).

2-35

The following T-accounts illustrate the effect

that this adjusting entry would have on the

relevant accounts:

Whether the initial debit is made to

Prepaid Insurance or Insurance Expense,

the ending balances will be the same if the

proper adjusting entry is made.

Prepaid Expenses Originally Debited to an

Asset Account

2-36

Unearned Revenues

• Amounts received before the actual earning

of revenues are known as unearned

revenues.

• Because the company has received cash

but not yet given the customer the

purchased goods or services, the unearned

revenues are in fact liabilities.

2-37

Unearned Revenues Originally Credited to a

Revenue Account

(f) As indicated in the trial balance for Rosi,

Inc., rent receipts are recorded originally in

the rent revenue account. Unearned

revenue at the end of 2013 is $475, and is

recorded as follows:

(continued)

Rent Revenue 475

Unearned Rent Revenue 475

To record unearned rent

revenue.

2-38

Unearned Revenues Originally Credited to a

Revenue Account

The following T-accounts illustrate the effect

that this adjusting entry would have on the

related accounts.

2-39

Unearned Revenues Originally Credited to a

Liability Account

If a liability account was originally credited,

this account is debited and a revenue

account is credited for the amount applicable

to the current period.

(continued)

Unearned Rent Revenue 2,075

Rent Revenue 2,075

To record rent revenue

($2,550 – $475).

2-40

The following T-accounts illustrate the effect

that this adjusting entry would have on the

relevant accounts:

Unearned Revenues Originally Credited to a

Liability Account

2-41

Transactions Involving Estimates

• Accountants must constantly use judgment

when applying the accrual accounting

model.

• Questions such as how many periods will

a machine generate revenues or how

many credit customers will not pay must

be answered and reflected in the financial

statements by using estimations.

(continued)

2-42

• Operations are charged with a portion of

the asset’s cost, and the carrying value of

the asset is reduced by that amount.

• A reduction in an asset for depreciation is

usually recorded by a credit to a contra

account, which is set up to record

subtractions from related accounts.

(continued)

Transactions Involving Estimates

Asset Depreciation Asset Depreciation

2-43

(g) Rosi Inc., estimated depreciation at the

end of the year to be five percent for

buildings and ten percent for furniture and

equipment.

(continued)

Transactions Involving Estimates

Depreciation Expense—Building 7,800

Accumulated Depreciation—

Building 7,800

To record depreciation on

buildings at 5% per year.

Asset Depreciation Asset Depreciation

2-44

(g)

Transactions Involving Estimates

Depreciation Expense—Furniture

& Fixtures 1,900

Accumulated Depreciation—

Furniture & Fixtures 1,900

To record depreciation on

furniture and equipment at

10% per year.

Asset Depreciation Asset Depreciation

2-45

Bad Debts

• Invariably, when a business allows customers to

purchase goods and services on credit, some of the

accounts receivable will not be collected.

• Under the accrual concept, an adjustment should be

made for estimated expense in the current period

rather than when specific accounts become

uncollectible.

(continued)

(i) Rosi Inc.’s estimated Allowance for Bad

Debts is to be increased by $1,100.

Bad Debt Expense 1,100

Allowance for Bad Debts 1,100

To adjust for estimated bad

debt expense.

2-46

Adjusting Entry Summary

• Adjusting entries do not involve cash.

• Adjusting entries always involve a balance sheet account and an income statement account.

2-47

Preparing Financial Statements

1. Identify all revenues and expenses—these

account balances are used to prepare the

income statement.

2. Compute the net income—subtract expenses

from revenues.

3. Compute the ending Retained Earnings

balance.

4. Prepare a balance sheet using the balance

sheet accounts from the trial balance and the

modified retained earnings balance.

2-48

An optional step in the accounting process is

to use a spreadsheet (also called a work

sheet) to facilitate the preparation of

adjusting entries and financial statements.

The availability of spreadsheet software

makes the preparation of a spreadsheet

quite easy. A spreadsheet for Rosi, Inc, is

shown on the following slides.

(continued)

Using a Spreadsheet

2-49 2-49

(continued)

2-50 2-50

(continued)

2-51

(concluded)

2-51

2-52

• Nominal (or temporary) accounts:

Closed to a zero balance at the end of

each accounting period.

All income statement accounts and the

dividend account are closed.

• Real (or permanent) accounts:

Not closed to a zero balance at the end

of the accounting period.

Carried forward to the next period.

Using a Spreadsheet

2-53

Revenues

Bal. xxx

Retained Earnings

Beg. Bal. xxx xx

Since the revenue account is a

nominal account, it is closed at

the end of the period to

Retained Earnings.

Revenues

The Closing Process

(continued)

2-54

Expenses

Bal. xxx

Each expense account

is credited in order to

close the account at

the end of the period.

Expenses

Retained Earnings

Beg. Bal. xxx

xx

Revenues

The Closing Process

(continued)

2-55

Dividends

Bal. xxx

The dividends

account, which is

also nominal, is

credited to close

out the balance.

Expenses

Retained Earnings

Beg. Bal. xxx

Revenues Dividends

x

x

The Closing Process

(continued)

2-56

Revenues

Retained Earnings

is a real account

and always carries

a balance.

Dividends reduce

Retained Earnings.

Retained Earnings

Beg. Bal. xxx Expenses

Dividends

Net Income for the

period is determined

by these two items.

The Closing Process

2-57

The Closing Process for Rosi, Inc.

(continued)

2-58

The Closing Process for Rosi, Inc.

2-59

The Closing Process for Rosi, Inc.

2-60

• Provides a listing of all real account

balances at the end of the closing process.

• The post-closing trial balance is

prepared to verify the equality of debits

and credits for all real accounts.

Post-Closing Trial Balance

2-61

Post-Closing Trial Balance

(continued)

2-62

Post-Closing Trial Balance

2-63

• Accrual accounting recognizes revenues as

they are earned, not necessarily when cash is

received.

• Expenses are recognized as they are incurred,

not necessarily when cash is paid.

• Provides a better basis for financial reporting,

according to the FASB.

Accrual Accounting

4. Accrual and Cash-basis Accounting

2-64

• Cash-basis accounting is focused on cash

receipts and cash disbursements.

• Typically used by service businesses, such

as CPAs, dentists, and engineers.

• AICPA holds that it is appropriate for small

service companies.

Cash-Basis Accounting

2-65

• Many steps of the accounting cycle are

performed using computers.

• Typical computerized functions include

generating reports and computational

analysis.

• The computer will never replace a good

accountant!

Computers and Accounting

(continued)

5. Importance and Expanding Role of

Computers to the Accounting Process

2-66

A recent development in the use of computers in

financial reporting is the spread of XBRI:

• Stands for eXtensible Business Reporting

Language.

• Is a method of embedding computer-readable

tags in financial report documents.

• Allows a company to download its financial

statements into spreadsheets where they can

be compared to the financial statements of

other companies that have also been

downloaded.

Computers and Accounting