the Accounting Cycle

The Accounting Cycle

Chapter # 2

Resource person: Furqan-ul-haq Siddiqui

References:

Accounting the Basis for Business Decision . By: Meigs, Williams, Haka, Betner (9th/11th edition)

Internet

The Role of Accounting RecordsMany businesses have several hundred or even

thousand business transactions each day. Is it possible for business to prepare balance

sheet after every transaction…….? o Yes / NoAccounting transactions are recorded in the

accounting books and at the end of year accounting period, a balance sheet is prepared from these transactions. 2

Illustration 3-1

Transaction Identification Process

Recording ProcessSteps 1, 2, and 3 of Accounting Cycle

The General The General JournalJournalThe General The General JournalJournal Transactions are initially recorded in chronological order in a

journal before being transferred to the accounts. The general journal is an accounting log book that contains a

complete listing of a company's accounting transactions documented in chronological order, and using the double-entry method of bookkeeping.

Entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount. The total amount debited and the total amount credited should always be equal, thereby ensuring the accounting equation is maintained.

JournalizingJournalizingJournalizingJournalizing

Entering transaction data in the journal is known as journalizing.

Separate journal entries are made for each transaction.

A complete entry consists of:

a. the date of the transaction,

b. the accounts and amounts to be debited and credited, and

c. a brief explanation of the transaction.

7

GENERAL JOURNAL

Date Account Titles and ExplanationPR Debit Credit

2003

May 1 Cash 8,000

Capital Stock 8,000

Owners invest cash in the business.

Debit & Credit In accounting, "debit" and "credit" have the

following meanings: Debit -"Enter in the left column of" Credit- "Enter in the right column of“That's all. Debit refers to the left column;

credit refers to the right column. The term debit comes from the Latin debitum which means "that which is

owing" (the past participle of debitere "to owe"). Debit is abbreviated to Dr (for debtor who owes money to the company). The term credit comes from the Latin credere/credit meaning "to trust or believe"/"he trusts or believes" via the French credit and the Italian credito 8

Each transaction consists of debits and credits For Every Transaction:

The Value of Debits = The Value of Credits The basic accounting equation is as follows: Assets = Equity + Liabilities (A = E + L)

9

Expanded Accounting Equation

The entire group of accounts is kept together in an

accounting record called a ledger.The entire group of accounts is kept together in an

accounting record called a ledger.

An account is an individual record showing increases and decreases in a single balance sheet item e.g. Asset, Liability, or Shareholders’ Equity itemThree parts:

1) The title of the account2) A left or debit side3) A right or credit side

An account is an individual record showing increases and decreases in a single balance sheet item e.g. Asset, Liability, or Shareholders’ Equity itemThree parts:

1) The title of the account2) A left or debit side3) A right or credit side

Steps 1, 2, and 3 of Accounting Cycle

The Use of Accounts

Increases are recorded on one

side of the T-account, and decreases are

recorded on the other side.

Left or

Debit Side

Right or

Credit Side

Title of Account

20

Posting Journal Entries to the Ledger Accounts

Posting involves copying information from the journal to the ledger accounts.

Account Name

Debit / Dr. Credit / Cr.

Debits and CreditsDebits and CreditsDebits and CreditsDebits and CreditsIf Debit entries are greater thangreater than Credit entries, the account will have a debit balance.

$10,000 Transaction #2$3,000

$15,000$15,000

8,000Transaction #3

Balance

Transaction #1

Account Name

Debit / Dr. Credit / Cr.

Debits and CreditsDebits and CreditsDebits and CreditsDebits and CreditsIf Credit entries are greater thangreater than Debit entries, the account will have a credit balance.

$10,000 Transaction #2$3,000

$1,000$1,000

8,000 Transaction #3

Balance

Transaction #1

General LedgerCash

Date Debit Credit Balance2003

May 1 8,000 8,000 2 2,500 5,500

This ledger format is referred to as a running balance (as opposed to simple

T accounts).

This ledger format is referred to as a running balance (as opposed to simple

T accounts).

Ledger Accounts After Posting

Net income is not an asset it’s an increase in owners’ equity from profits of the business.

Net income is not an asset it’s an increase in owners’ equity from profits of the business.

AA = LL + OEOEIncrease Decrease Increase

Either (or both) of these effects occur as net income

is earned . . .

. . . but this is what “net income”

really means.

What is Net Income?

AA = LL + OEOERetained Earnings

Capital Stock

Retained Earnings

The balance in the Retained Earnings account represents the total net income of the corporation over the entire lifetime of the business, less all amounts which have been distributed to the stockholders as dividends.

Net Income = Revenue - Expenses

The price for goods sold

and services rendered during a given accounting

period.

Increases owner’s equity.

The costs of goods and services used up

in the process of earning revenue.

Decreases owner’s equity.

The Realization Principle: When To Record Revenue

Realization Principle

Revenue should be recognized at the time

goods are sold and services are rendered.

On July 25 a radio station contracts with a car dealership to air a series of one-minute advertisements during August. If all of the agreed-upon ads are aired in August, but payment for the ads is not received until September, in which month should the station recognize the advertising revenue? The month in which it rendered the services that

earned the advertising revenue. In other words, revenue is recognized when it is

earned, without regard to when a contract is signed or when cash payment for providing goods or services is received. 33

The Matching Principle: When To Record Expenses

Matching PrincipleExpenses should be

recorded in the period in which they

are used up.

The salaries earned by a company’s marketing team for serving customers in July are not paid until early August. In which month should these salaries be regarded as expenses—July or August? The answer is July, because July is the month in

which the marketing team’s services helped to produce revenue.

In deciding when to report an expense in the income statement, the critical question is, “In what period does the cash expenditure help to produce revenue?”— not, “When does the payment of cash occur?”

35

Expenditures Benefiting More than One Accounting Period

Many expenditures made by a business benefit two or more accounting periods.

If a company prepares monthly income statements, then allocates only proportion of expense which is actually incurred for that month.

If the 12-month Insurance policy costs $2,400, the insurance expense for each month amounts to $200 ($2,400 cost/12 months).

36

The Accrual & Cash Basis of Accounting The method of recognizing revenue in the accounting

records when it is earned and recognizing expenses when the related goods or services are used is called the accrual basis of accounting.

The purpose of accrual accounting is to measure the profitability of the economic activities conducted during the accounting period.

In cash basis of accounting, revenue is recognized when cash is collected from the customer, rather than when the company sells goods or renders services and same with expenses.

37

Expanded Accounting Equation

If an entry involves only two accounts, one debit and one credit, it is considered a simple entry.

If an entry involves only two accounts, one debit and one credit, it is considered a simple entry.

SIMPLE AND COMPOUND JOURNAL ENTRIESSIMPLE AND COMPOUND JOURNAL ENTRIESSIMPLE AND COMPOUND JOURNAL ENTRIESSIMPLE AND COMPOUND JOURNAL ENTRIES

When three or more accounts are required in one journal entry, the entry is referred to as a compound entry.

When three or more accounts are required in one journal entry, the entry is referred to as a compound entry.

COMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRY

2

1

3

COMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRYCOMPOUND JOURNAL ENTRY

This is the wrong format; all debits must be listed before the credits are listed.

This is the wrong format; all debits must be listed before the credits are listed.

Journalize transactions.

Post entries to the ledger accounts.

Prepare trial balance.

Make end-of-accounting period

adjustments.

Prepare adjusted trial balance.

Prepare financial

statements.

Prepare after closing trial balance.

Journalize and post closing

entries.


The Trial Balance Before using the account balances to prepare a balance

sheet, it is desirable to prove that the total of accounts with debit balances is in fact equal to the total of accounts with credit balances.

This proof of the equality of debit and credit balances is called a trial balance.

A trial balance is a two-column schedule listing the names and balances of all the accounts in the order in which they appear in the ledger ;

the debit balances are listed in the left-hand column and the credit balances in the right-hand column.

The totals of the two columns should agree. 43

that the trial balance contains both balance sheet and income statement accounts.

Suppose that the debit and credit totals of the trial balance do not agree. This situation indicates that one or more errors have been made.

Typical of such errors are;

1. the posting of a debit as a credit, or vice versa;

2. arithmetic mistakes in determining account balances;

3. clerical errors in copying account balances into the trial balance;

4. listing a debit balance in the credit column of the trial balance, or vice versa; and

5. errors in addition of the trial balance. 44

Adjusting Entries Adjusting entries are journal entries usually made

at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred.

Adjusting Entries bring certain account balances up to date at the end of the accounting period.

They are sometimes called Balance Day adjustments because they are made on balance day.

Adjusting Entries are necessary when accrual basis accounting is used. 45

Reason for Adjustments It can be inefficient and costly to account for certain types

of transactions on a daily basis.

An example of the inefficiency of recording certain transactions follows:

Each time an employee removes a pen from the supplies closet, a journal entry debiting Supplies Expense and crediting Supplies for $1.25 (estimated cost of pen) should be recorded. However, it would be very costly and inefficient to try to keep up with each little transaction like this. So instead, we wait until the end of the accounting period and determine the total amount of supplies used. Then we make one adjusting entry to account for all the supplies used during the period.

Generally a month, a quarter, or a year.

Fiscal year vs. calendar year

Also known as the “Periodicity Assumption”

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

Jan. Feb. Mar. Apr. Dec.. . . . .

Timing Issues

GAAP relationships in revenue and expense recognitionGAAP relationships in revenue and expense recognition

Adjusting entries are required each time financial statements are prepared.

Adjusting entries can be classified as Prepayments (prepaid expenses or unearned revenues), accruals (accrued revenues or accrued expenses), or estimates (Depriciation).

Prepayments

1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned.

Accruals

1. Accrued Revenues — Revenues earned but not yet received in cash or recorded.

2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.

Estimates

1. Depreciation — Allocation of the cost of capital assets to expense over their useful lives.

ADJUSTED TRIAL BALANCEADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all

adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of

the accounting period and the effects of all financial events that have occurred during the period.

It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made.

Financial statements can be prepared directly from the adjusted trial balance.

Debit Credit Debit CreditCash 15,200$ 15,200$ Accounts Receivable 200 Advertising Supplies 2,500 1,000 Prepaid Insurance 600 550 Office Equipment 5,000 5,000 Accumulated Amort'n. 83$ Notes Payable 5,000$ 5,000 Accounts Payable 2,500 2,500 Unearned Revenue 1,200 800 Salaries Payable 1,200 Interest Payable 25 C.R. Byrd, Capital 10,000 10,000 C.R. Byrd, Drawings 500 500 Service Revenue 10,000 10,600 Adv. Supplies Expense 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 4,000 5,200 Rent Expense 900 900 Interest Expense 25

28,700$ 28,700$ 30,208$ 30,208$

Pioneer Advertising AgencyTrial Balance

October 31, 2002Before Adjustment After Adjustment

Trial Balance And Adjusted Trial Balance ComparedTrial Balance And Adjusted Trial Balance Compared Trial Balance And Adjusted Trial Balance ComparedTrial Balance And Adjusted Trial Balance Compared

Preparing Financial StatementsPreparing Financial StatementsFinancial statements can be prepared directly from an adjusted trial balance.

1.The income statement is prepared from the revenue and expense accounts.2.The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement.3.The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.

Preparation of the income statement and the statement of Preparation of the income statement and the statement of owner’s equity from the adjusted trial balanceowner’s equity from the adjusted trial balance

RevenuesService Revenue 10,600$

ExpensesAdv. Supplies Expense 1,500$ Amortization Expense 83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25 Total Expenses 7,758

Net Income 2,842$

Pioneer Advertising AgencyIncome Statement

For the Month Ended October 31, 2002

C.R. Byrd, Capital, October 1 -$ Add: Investments 10,000 Net income 2,842

12,842 Less: Drawings 500 C.R. Byrd, Capital, October 31 12,342$

Statement of Owner's EquityFor the Month Ended October 31, 2002

Pioneer Advertising Agency

Debit CreditCash 15,200$ Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Amort'n. 83$ Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 25 C.R. Byrd, Capital 10,000 C.R. Byrd, Drawings 500 Service Revenue 10,600 Adv. Supplies Expense 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25

30,208$ 30,208$

Pioneer Advertising AgencyAdjusted Trial Balance

October 31, 2002

Debit CreditCash 15,200$ Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Amort'n. 83$ Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 25 C.R. Byrd, Capital 10,000 C.R. Byrd, Drawings 500 Service Revenue 10,600 Adv. Supplies Expense 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25

30,208$ 30,208$

Pioneer Advertising AgencyAdjusted Trial Balance

October 31, 2002

Cash 15,200$ Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000$ Less: Accumulated Amortization 83 4,917

Total Assets 21,867$

Liabilities and Owner's EquityLiabilities Notes Payable 5,000$ Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 25

Total Liabilities 9,525$ Owner's EquityC.R. Byrd, Capital 12,342 Total Liabilities and Owner's Equity 21,867$

October 31, 2002Assets

Pioneer Advertising AgencyBalance Sheet

Preparation of the balance sheet from the adjusted Preparation of the balance sheet from the adjusted trial balancetrial balance

Preparation of the balance sheet from the adjusted Preparation of the balance sheet from the adjusted trial balancetrial balance

From Statement of Owner’s

Equity

From Statement of Owner’s

Equity

56

The Accounting Worksheet Used to help move data from the trial balance to the

financial statements An internal document – not financial statement multiple-column form used for the adjustment

process and preparing financial statements working tool for the accountant not a permanent accounting record Eases preparation of adjusting entries and financial

statements

A work sheet is not a permanent accounting record

When it is used:financial statements are prepared from the work

sheetadjustments are journalized and posted from the

work sheet after financial statements, so management can receive the financial statements more quickly

Remember

To Prepare A Work Sheet

1. Prepare the trial balance

2. Enter adjustments in the adjustments columns

3. Enter adjusted balances in adjusted trial balance columns

4. Extend adjusted trial balance amounts to the appropriate financial statement columns

5. 5 Total the statement columns, compute net income (loss), and complete the work sheet

Now, let’s see how this works!

Example of a Work Sheet

FastForwardWork Sheet

For Month Ended December 31, 2004

First, enter the

unadjusted trial balance amounts to

the worksheet!

First, enter the

unadjusted trial balance amounts to

the worksheet!

Here are our adjusting entries for December.

a) Insurance expense 100

Prepaid insurance 100

b) Supplies expense 1050

Supplies 1050

c) Depreciation expense 375

Accum. Depr. – Equip. 375

Here Are More Adjusting Entries for December.

d) Unearned revenue 250

Consulting Revenue 250

e) Salaries Expense 210

Salaries Payable 210

f) Accounts Receivable 1,800

Consulting Revenue 1,800

Next, enter the adjustments!

Next, enter the adjustments!



Prepare the adjusted trial

balance!

Prepare the adjusted trial

balance!





Then, extend the adjusted trial balance amounts to the financial statements!

Then, extend the adjusted trial balance amounts to the financial statements!



Total statement columns, compute income or loss, and balance columns.

Total statement columns, compute income or loss, and balance columns.

Prepare the IncomeStatement.

Prepare the Financial Statements

A work sheet does not

substitute for financial

statements.

A work sheet does not

substitute for financial

statements.

Prepare the Statement of Changes in Owner’s Equity.

FastForwardBalance Sheet

December 31, 2004

AssetsCash 3,950$ Accounts receivable 1,800 Supplies 8,670 Prepaid insurance 2,300 Equipment 26,000$ Less: accum. depr. (375) 25,625 Total assets 42,345$

LiabilitiesAccounts payable 6,200$ Salaries payable 210 Unearned consulting revenues 2,750 Total liabilities 9,160$

Owner's EquityC.Taylor, Capital 33,185 Total liabilities and equity 42,345$

FastForwardBalance Sheet

December 31, 2004

AssetsCash 3,950$ Accounts receivable 1,800 Supplies 8,670 Prepaid insurance 2,300 Equipment 26,000$ Less: accum. depr. (375) 25,625 Total assets 42,345$

LiabilitiesAccounts payable 6,200$ Salaries payable 210 Unearned consulting revenues 2,750 Total liabilities 9,160$

Owner's EquityC.Taylor, Capital 33,185 Total liabilities and equity 42,345$

Prepare the Balance Sheet.

70

Closing Entries Lets, we are reporting sales and expenses for January,

for example, February sales and expenses should start with a zero balance to properly report sales, expenses, and net income only for the month of February.

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts that are reset at the end of the accounting period so that they will have zero balances at the start of the next period.

Closing entries are the journal entries used to transfer the balances of these temporary accounts to permanent accounts.

Temporary vs. Permanent AccountsTEMPORARY (NOMINAL) PERMANENT (REAL) These accounts are closed These accounts are not closed

All revenue accounts All asset accounts

All expense accounts All liability accounts

Owner’s drawing Owner’s capital account

Now, let’s talk about closing entries and income summary!

CLOSING ENTRIES

Closing entries Transfer net income (loss) and owner’s drawings to

owner’s capital Journalizing and posting is a required step in the

accounting cycle

Income Summary A temporary account Used in closing revenue and expense accounts Minimizes the details in the permanent owner’s capital

account

Resets revenue, expense and withdrawal account balances to zero at the end of the period.

Helps summarize a period’s revenues and expenses in the Income Summary account.

Identify accounts for closing.

Record and post closing entries.

Prepare post-closing trial balance.

Closing Process

Temporary Accounts

Revenues

Income Summary

Exp

ense

s

With

draw

als

Permanent Accounts

Assets

Lia

bili

ties

Ow

ner’s

Cap

ital

The closing process applies only to

temporary accounts.

The closing process applies only to

temporary accounts.

Temporary and Permanent Accounts

Let’s see how the closing process

works!

Recording Closing Entries

Close Revenue accounts to Income Summary.

Close Expense accounts to Income Summary.

Close Income Summary account to Owner’s Capital.

Close Withdrawals to Owner’s Capital.

Close Revenue accounts to Income Summary.

Close Expense accounts to Income Summary.

Close Income Summary account to Owner’s Capital.

Close Withdrawals to Owner’s Capital.

Balances before closing.

Income Summary

Owner's Capital30,000

30,000

Revenue Accounts25,000

25,000

Withdrawals Account5,000

5,000

Expense Accounts10,000

10,000

Closing Process

Income Summary25,000

25,000

Close Revenue accounts to Income

Summary.

Owner's Capital30,000

30,000

Revenue Accounts25,000 25,000

-


5,000

Expense Accounts10,000

10,000

Closing Process

Income Summary10,000 25,000

15,000 Owner's Capital30,000

30,000


-


5,000

Close Expense accounts to Income

Summary.

Expense Accounts10,000 10,000

-

Closing Process

The balance in Income Summary equals net

income.

The balance in Income Summary equals net

income.

Owner's Capital30,000 15,000

45,000


45,000


5,000


5,000

Close Income Summary to

Owner’s Capital.


-


-

Income Summary10,000 25,000 15,000

-

Closing Process


45,000


15,000

40,000


5,000

Withdrawals Account5,000 5,000

-


-


-

Income Summary10,000 25,000 15,000

-

Closing Process

Close Withdrawals account to Owner’s

Capital.

Using the adjusted trial balance, let’s prepare the

closing entries for

FastForward.

Close Revenue accounts to

Income Summary.

Close Revenue Accounts to Income Summary

Dec. 31 Consulting revenue 7,850 Rental revenue 300

Income summary 8,150

Dec. 31 Consulting revenue 7,850 Rental revenue 300

Income summary 8,150

Now, let’s look at the ledger accounts after posting this closing entry.


Close Expense Accounts to Income Summary

Dec. 31 Income summary 4,365Depreciation expense-Equipment 375Salaries expense 1,610Insurance expense 100Rent expense 1,000Supplies expense 1,050Utilities expense 230

Income Summary4,365 7,850

300 3,785

Utilities Expense230 230

-

Rent Expense1,000 1,000

-

Net Income

Close Expense Accounts to Income Summary Close Expense Accounts to Income Summary Close Expense Accounts to Income Summary

Supplies Expense1,050 1,050

-

Depreciation Expense- Eq.

375 375 -

Salaries Expense1,610 1,610

-

Insurance Expense100 100

-

Close Income Summary to

Owner’s Capital.


Close Income Summary to Owner’s Capital

Dec. 31 Income summary 3,785C. Taylor, Capital 3,785

C. Taylor, Capital30,000 3,785

33,785

Close Income Summary to Owner’s Capital Close Income Summary to Owner’s Capital Close Income Summary to Owner’s Capital

Income Summary4,365 7,850 3,785 300

-

Close Withdrawals to

Owner’s Capital.


Close Withdrawals to Owner’s Capital

Dec. 31 C. Taylor, Capital 600C. Taylor, Withdrawals 600

C. Taylor, Capital600 30,000

3,785

33,185

C. Taylor, Withdrawals

600 600

-



About Closing Entries

Be Careful!

Remember: owner’s drawing does not move to

the Income Summary account. Owner’s drawing

is not an expense and it is not a factor in

determining net income.

POST-CLOSING TRIAL BALANCE

After all closing entries have been journalized the post-closing trial balance is prepared from the ledger.

The purpose of this trial balance is to prove the equality of the permanent account balances that are carried forward into the next accounting period.

Let’s look at FastForward’s

post-closing trial balance.

Post-Closing Trial Balance

List of permanent accounts and their balances after posting closing entries.

Total debits and credits must be equal.

List of permanent accounts and their balances after posting closing entries.

Total debits and credits must be equal.

Post-Closing Trial Balance

Journalize transactions.

Post entries to the ledger accounts.

Prepare trial balance.

Make end-of-accounting period

adjustments.

Prepare adjusted trial balance.

Prepare financial

statements.

Prepare after closing trial balance.

Journalize and post closing

entries.


What is the difference between accounts payable and notes payable?

Notes Payable involves a written promissory note. For example, if your company wishes to borrow $100,000 from its bank, the bank will require company officers to sign a formal loan agreement before the bank provides the money.

Contrast the bank loan with phoning one of your company’s suppliers and asking for a delivery of products or supplies. On the next day the products arrive and you sign the delivery receipt. A few days later your company receives an invoice from the supplier and it states that the payment for the products is due in 30 days. 97

This transaction did not involve a promissory note. As a result, this transaction is recorded in your company’s general ledger account Accounts Payable.

Accounts payable are amounts due to vendors in the normal course of business, such as for rent and utilities, supplies, and the like.

98

the Accounting Cycle

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