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A Review of the Accounting Cycle

Chapter 2

S t I c e | S t I c e | S k o u s e n

Intermediate Accounting

16E

Learning Objectives

1. Identify and explain the 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.

Overview of the Accounting Process

Step 1Business documents analyzed

Step 2Transactions recorded in journals

Step 3Transactions posted to ledgers

Recording Phase

Step 5Adjustments

Work sheet (optional)

Step 4Trial balance

Steps in the Reporting

Phase

Step 6Financial statements

Step 7Closing entries

Step 8Post-closing trial balance (optional)

Stop & Think

Which of the following would NOT be the role

of a bookkeeper?

Double Entry Accounting

• The accepted system for recording accounting data.

• Each transaction/ business event is recorded to maintain the equality of:

The basic accounting equation

Assets = Liabilities Owners’ Equity+

Journalizing Transactions• Transactions are events that have an

economic impact on a business.

• Business documents are records that are evidence of transactions.

• A journal is an accounting record in which business transactions are entered in chronological order.

Journal Entry Process

Every journal entry involves a 3-step process:

1. Identify the accounts involved with an event or transaction.

2. Determine whether each account increased or decreased.

3. Determine the amount by which each account was affected.

Debits and Credits

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

• A credit is an entry on the right side.

General Journal Entry FormatDate Debit Entry.................................. xx

Credit Entry............................. xx Explanation

• Debits and credits affect accounts differently.

Debit & Credit EffectsAssets

DR CR

+ -

Liabilities

DR CR

- +

Owners’ EquityDR CR

- +

Dividends

DR CR+ -

Capital Stock

DR CR

Retained Earnings

DR CR- + - +

Expenses

DR CR

Revenues

DR CR+ - - +

= +

Types of Journals

• The general journal is used to record all transactions.

• A special journal is used to record a particular type of frequently recurring transaction.– Sales, Purchases, Cash Disbursements,

Cash Receipts

Date DescriptionPostRef. Debits Credits

General JournalPage 4

2005June 15 Cash 330 15,000

Wages Payable 260 15,000Payment of wages for June.

25 Accounts Receivable 180 5,500Sales Revenue 220 5,500

Revenue earned on account. .

Example: Journal Entry

On January 2, sold merchandise costing $60 to a customer on

account for $75. Make the journal entry.

Example: Journal Entry

Jan. 2 Accounts Receivable..................... 75 Sales Revenue.......................... 75

Sold merchandise on account.

2 Cost of Goods Sold...................... 60 Inventory................................. 60

To record cost and reduce inventory.

This entry assumes that the perpetual system is used.

This entry assumes that the perpetual system is used.

Posting to the Ledger Accounts

• Posting is the process of transferring amounts from the journal to the general ledger.

• A ledger is a collection of accounts in which data from transactions recorded in the journals are posted, classified, and summarized.

• A chart of accounts lists all accounts used by the company.

3. Posting to the Ledger Accounts

The Accounts Receivable account in the general ledger after revenue was earned on

June 25 has been posted:

Account Accounts Receivable Account No: 180

Date Item PR Debit Credit Balance

2005 June 1 Balance 10,550 25 Accounts Receivable J24 7,500 3,050

Stop & ThinkWhich of the following posting errors could a person make that a computer would not?

Which of the following posting errors could a person make that a computer would not?

Typical Chart of Accounts

ASSETS (100-199)Current Assets (100-150)101 Cash105 Accounts Receivable107 Inventory

Long-Term Assets (151-199)151 Land152 Building

LIABILITIES (200-299)Current Liabilities (200-219)201 Notes Payable202 Accounts Payable

Long-Term Liabilities (220-239)222 Mortgage Payable

OWNERS’ EQUITY (300-399)301 Capital Stock330 Retained Earnings

SALES (400-499)400 Sales Revenue

EXPENSES (500-599)500 Cost of Goods Sold523 Rent Expense528 Advertising Expense573 Utility Expense

Reporting Phase

4. A trial balance is prepared.5. Adjusting entries are

recorded.6. Financial statements are

prepared.7. Closing entries are made.8. A post-closing trial balance is

prepared (optional).

Preparing a Trial Balance

• Determine the account balance for each T-Account.

• A trial balance is a list of all accounts and their balances.

• It provides a means to assure that debits equal credits.

XYZ CompanyTrial Balance

December 31, 2005

Debits CreditsCash $ 21Accounts Receivable 15Inventory 12Land 200Accounts Payable $ 30Capital Stock 150Retained Earnings 24Sales Revenue 919Cost of Goods Sold 850Advertising Expense 10Misc. Expenses 15 ______ Total $ 1,123 $ 1,123

Preparing Adjusting Entries

• Adjusting entries are required at the end of each accounting period prior to preparing the financial statements.

• The purpose for adjusting entries are to:

• bring balance sheet accounts current.

• reflect proper amounts of revenues, costs, and expenses on the income statement.

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

Adjusting entries never involve a cash account.

You can not memorize adjusting entries.

Tips for Adjusting Entries

• Unrecorded Revenues -Revenues that have been earned but not yet recorded.

• Unearned Revenues -Revenues that have been recorded but not yet earned.

• Unrecorded Expenses-Expenses that have been incurred but not yet recorded.

• Prepaid Expenses-Expenses that have been recorded but not yet incurred.

Most Common Adjusting Entries

1. Identify the original entries that were made, if any. • Original entries are only made for

unearned revenues and prepaid expenses.

2. Determine what the correct balances should be at this point in time.

3. Make the adjustments needed to bring the balances to the desired amounts.

Three Step Process for Adjusting Entries

Adjusting Entry

12/31 Depreciation Expense—Buildings 7,800 Accumulated Depr.—Buildings 7,800

To record depreciationon building at 5% per year.

Asset Depreciation

Rosi, Inc. purchased buildings in 2000 at a cost of $156,000, an expected life of 20 years, and no anticipated residual value. Each year, 5% of the cost is depreciated. At the end of 2005, the following adjusting entry is made:

An estimation of bad debts based on the ending receivables balance reveals that the allowance account needs to be increased by $1,100.Adjusting Entry 12/31 Bad Debts Expense 1,100

Allowance for Bad Debts 1,100

To adjust for estimated bad

debts expense.

Bad Debts

Later, on March 19 that a $150 receivable is deemed to be uncollectible. Using the allowance account, the uncollectible account is written off the books.

3/19 Allowance for Bad Debts 150Accounts Receivable 150

To write off an uncollectibleaccount.

Bad Debts

Note that this entry is not an adjusting entry. It is made when the

account is determined to be uncollectible.

At the end of the fiscal period, Rosi, Inc. had accrued salaries and wages totaling $2,150.

Adjusting Entry 12/31 Salaries and Wages Expense 2,150

Salaries and Wages Payable 2,150To record accrued salaries andwages.

Accrued Expenses

Rosi, Inc. holds a note receivable from a customer on which interest total $250 has accrued.

Adjusting Entry 12/31 Interest Receivable 250

Interest Revenue 250To record accrued interest on anote receivable.

Accrued Revenues

Rosi, Inc.’s trial balance shows that the asset account Prepaid Insurance has a balance of $8,000. By December 31, only $3,800 applies to future periods.

Adjusting Entry 12/31 Insurance Expense 4,200

Prepaid Insurance 4,200To record expired insurance.

$8,000 – $3,800$8,000 – $3,800

Original debit to an asset accountOriginal debit to an asset account

Prepaid Expenses

Rosi, Inc.’s trial balance shows that the asset account Insurance Expense has a balance of $8,000. By December 31, $3,800 applies to future periods.

Adjusting Entry 12/31Prepaid Insurance 3,800

Insurance Expense 3,800To record expired insurance.

$8,000 – $4,200$8,000 – $4,200

Original debit to an expense accountOriginal debit to an expense account

Prepaid Expenses

Rosi, Inc. receives a payment of $2,550 from a customer prior to the services being rendered. By December 31, $2,075 in services have been provided.

Adjusting Entry 12/31Rent Revenue 475

Unearned Rent Revenue 475To record unearned rent revenue.

Original credit to a revenue accountOriginal credit to a revenue account

$2,550 – $2,075$2,550 – $2,075

Deferred Revenues

Adjusting Entry 12/31 Unearned Rent Revenue 2,075

Rent Revenue 2,075To record rent revenue.

Rosi, Inc. receives a payment of $2,550 from a customer prior to the services being rendered. By December 31, $2,075 in services have been provided.$2,550 – $475$2,550 – $475

Original credit to a liability accountOriginal credit to a liability account

Deferred Revenues

Rosi, Inc.Trial Balance

December 31, 2005

Cash $ 83,110Accounts Receivable 106,500Allowance for Doubtful Accounts $ 1,610Inventory 45,000Prepaid Insurance 8,000Interest Receivable 0Notes Receivable 28,000Land 114,000Buildings 156,000Accumulated Depreciation—Buildings 39,000

Debit Credit

Partial Trial Balancefrom page 64 in your text

Rosi, Inc.Trial Balance

December 31, 2005

Dividends 13,600Sales 479,500Purchases 162,600Purchases Discounts 3,290Cost of Goods Sold 0Salaries and Wages Expense 172,450Heat, Light, and Power 32,480

Debit Credit

Partial Trial Balancefrom page 64 in your text

Adjusting Entry 12/31 Inventory 6,000

Purchases Discounts 3,290Cost of Goods Sold 153,310

Purchases 162,500To adjust inventory, cost ofgoods sold, and related accounts.

$51,000 – $45,000$51,000 – $45,000To closeTo close

To closeTo close

Purchases, Purchases Discounts, and Cost of Goods Sold are affected by the adjusting entry to update the inventory account.

Inventory

When a perpetual inventory system is

maintained, a separate

Purchases account is not used.

When a perpetual inventory system is

maintained, a separate

Purchases account is not used.

When a sale takes place, the sale is recorded similar to the periodic

inventory system.

When a sale takes place, the sale is recorded similar to the periodic

inventory system.The cost of the merchandise is recorded by a

debit to Cost of Goods Sold and

a credit to Inventory.

The cost of the merchandise is recorded by a

debit to Cost of Goods Sold and

a credit to Inventory.

Perpetual Inventory System

1. Record Transactions

2. Prepare Trial Balance

3. Make Adjusting Entries

4. Prepare Financial Statements

Preparing Financial Statements

Financial Statements

• Real accounts or permanent accounts • Not closed to a zero balance at the end of the

accounting period.• Carried forward to the next period.

• Nominal accounts or temporary accounts• Closed to a zero balance at the end of each

accounting period.• All Income statement accounts & Dividend

Account.• Closing entries reduce all nominal

accounts to a zero balance.

The Closing Process

Revenues Bal. xxx

Retained Earnings

Beg. Bal. xxxxxx

Since the revenue account is a nominal account, it is closed at

the end of the period to Retained Earnings.

Since the revenue account is a nominal account, it is closed at

the end of the period to Retained Earnings.

Revenues

The Closing Process

Expenses

Bal. xxx xxx The expense account is credited in order to close the account at

the end of the period.

The expense account is credited in order to close the account at

the end of the period.

Retained Earnings Beg. Bal. xxx RevenuesExpenses

The Closing Process

Dividends

Bal. xxx xxx

The dividends account, which is also nominal, is credited

to close out the balance.

The dividends account, which is also nominal, is credited

to close out the balance.

Retained Earnings

Beg. Bal. xxx RevenuesExpensesDividends

The Closing Process

Retained Earnings

Retained Earnings is a real account

and always carries a balance.

Retained Earnings is a real account

and always carries a balance.

Net Income for the period is determined by these two items.

Net Income for the period is determined by these two items.

Beg. Bal. xxx RevenuesExpensesDividends

End. Bal. xxx

Dividends reduce Retained EarningsDividends reduce Retained Earnings

The Closing Process

• Provides a listing of all real account balances at the end of the closing balance.

• The trial balance assures that total debits equal total credits prior to the beginning of the new accounting period.

• Only real accounts will have a balance at this time.

Post Closing Trial Balance

Jim Brewster, Inc.Post-Closing Trial Balanceas of December 31, 2004

Debits CreditsCash $ 8,200Accounts Receivable 4,000Inventory 3,000Supplies 1,000Accounts Payable $ 5,000Capital Stock 10,000Retained Earnings 1,200 Totals $16,200$16,200

Example: Post Closing Trial Balance

1. Analyze transactions and business documents.

2. Journalize transactions.3. Post journal entries to accounts.4. Determine account balances and

prepare a trial balance.5. Journalize and post adjusting entries.6. Prepare financial statements.7. Journalize and post closing entries.8. Prepare a post-closing trial balance.

Summary of the Accounting Cycle

Accrual Accounting

• Recognizes revenues as they are earned, not necessarily when cash is received.

• Recognizes expenses as they are incurred, not necessarily when cash is paid.

• Provides a better basis for financial reports, according to the FASB.

Cash Basis Accounting

• 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 companies.

Computers and Accounting

• Many steps of the accounting cycle are performed using computers.

• Typical computerized functions include, generating reports and computational analysis.

• But it will never replace a good accountant!