4 C H A P T E R Completing the Accounting Cycle

Learning Objective 1 Describe how accrual accounting allows for timely reporting and a better measure of a company's economic performance.

Why Use Accrual Accounting? Business requires periodic, timely reporting. Accrual-basis accounting better measures a firm’s performance that does cash flow data. 2

Define the Time Period Concept. Time Period Concept—the life of a business is divided into distinct and relatively short time periods so the accounting information can be timely, generally 12 months or less. 3

Financial Reports Most companies report to stockholders at fiscal year-end. Other reports are issued more frequently, perhaps monthly or quarterly. This frequency of reports forces accountants to use data based on judgments and estimates. ABC Inc. Annual Report

Define Accrual Accounting A system of accounting in which revenues and expenses are recorded as they are earned and incurred, not necessarily when cash is received or paid. Provides a more accurate picture of a company’s profitability. Statement users can make more informed judgments concerning the company’s earnings potential. 7

Revenue Recognition Revenues are recorded when two main criteria are met: What are they? The earning process is substantially complete Cash has either been collected or collection is reasonably assured. 8

Define The Matching Principle All costs and expenses incurred in generating revenues must be recognized in the same reporting period as the related revenues. This process of matching expenses with recognized revenues determines the amount of net income reported on the income statement. costs and expenses related revenues 9

Define Cash-Basis Accounting Revenues and expenses are recognized only when cash is received or payments are made. Mainly used by small businesses. Not an accurate picture of true profitability. 11

Example: Accrual- vs. Cash-Basis Accounting During 2002, Crown Consulting billed its client for $48,000. On December 31, 2002, it had received $41,000, with the remaining $7,000 to be received in 2003. Total expenses during 2002 were $31,000 with $3,000 of these costs not yet paid at December 31. Determine net income under both methods. Crown Consulting Reported Income for 2002 Accrual-Basis Accounting Revenues earned $48,000 Expenses incurred 31,000 Income $17,000 Cash-Basis Accounting Cash receipts $41,000 Cash disbursement 28,000 Income $13,000 14

Learning Objective 2 Explain the need for adjusting entries and make adjusting entries for unrecorded receivables, unrecorded liabilities, prepaid expenses, and unearned revenues.

What Are the Steps in the Accounting Cycle? 1. Analyze transactions and business documents. 2. Journalize transactions. 3. Post journal entries to ledger 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. Balance the accounts and prepare a post-closing trial balance. 15

Why DO Adjusting Entries? Adjusting entries are required at the end of each accounting period for accrual-basis accounting, prior to preparing the financial statements. To bring balance sheet accounts current. To reflect proper amounts of revenues and expenses on the Income Statement. 16

Adjusting Entries Tips Each adjusting entry always involves at least one income statement account and one balance sheet account. Adjusting entries never involve cash.

Define Each of These Common Adjusting Entries Always debit a Receivable & credit a Revenue for unrecorded receivables Always debit an Expense & credit a Liability for unrecorded liabilities Unrecorded Receivables Unrecorded Liabilities Prepaid Expenses Unearned Revenues Revenues earned but not yet recorded by period’s end. Expenses incurred but not yet recorded by period’s end. Payments made in advance for items normally charged to expense. Amounts received before the actual earning of revenues. Unrecorded Receivables & Liabilities will have no original entries.

What Is the 3-Step Process for Adjusting Entries? 1. Identify the original entries that were made (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 correct the balances. 19

Example: Unrecorded Receivables Bullseye Management earns a rent revenue of $500 in 2002 but will not receive the payment until January 10, 2003. An adjustment will be needed. What is the adjusting entry? Original entry none none Correct balances 500 500 Rent Receivable Rent Revenue Adjusting entry: 12/31/02 Rent Receivable 500 Rent Revenue 500 22

Example: Unrecorded Liabilities MoneyTree Inc. is assessed property taxes of $1,000 for 2002, but will not make this payment until January 5, 2003. An adjustment will be needed. What is the adjusting entry? Original entry none none Correct balances 1,000 1,000 Property Tax Expense Property Tax Payable Adjusting entry: 12/31/02Property Tax Expense 1,000 Property Tax Payable 1,000 22

Example: Prepaid Expenses On July 1, 2002, I Think I Can Inc. pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry? Rent Expense Prepaid Rent Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 Cash Adjusting entry: 12/31/02 Rent Expense 1,800 Prepaid Rent 1,800 22

Example: Unearned Revenues On July 1, 2002, Clean As A Whistle Co. received $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry? Unearned Rent Rent Revenue Cash Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 Adjusting entry: 12/31/02 Unearned Rent 1,800 Rent Revenue 1,800 22

Learning Objective 3 Explain the preparation of the financial statements, the explanatory notes, and the audit report.

Review The Steps in the Accounting Cycle 1. Analyze transactions and business documents. 2. Journalize transactions. 3. Post journal entries to ledger 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. Balance the accounts and prepare a post-closing trial balance. 15

Preparing Financial Statements Prepared directly from the data in the adjusted ledger accounts. Explanatory notes clarify the methods and assumptions. The auditor reviews the statements with GAAP.

What Are The Notes and Why Have Them? List assumptions and methods used in preparing financial statements. Give more detail about specific items. Serve to augment the summarized, numerical information.

Tell Me About The Audit Audits statements to check conformity with GAAP. Reviews adjustments. Samples selected accounts. Reviews accounting systems. Attaches report and distributes it with financial statements.

Learning Objective 4 Perform a systematic analysis of financial statements.

What Does The DuPont Framework Do? Summarizes the financial health of a company. Systematic approach for breaking down ROE into three ratios: 1. Profit margin (measure of profitability) 2. Asset turnover (measure of efficiency) 3. Assets-to-equity ratio (measure of leverage)

What Are the Components of ROE? Return on Equity = Net Income Equity Profitability x Efficiency x Leverage Asset Assets-to- Turnover Equity Ratio x Profit Margin Net Income x Revenue x Assets Revenue Assets Equity

Common-Size Financial Statements Divide all financial statement numbers for a given year by the total revenues for the year. All amounts are then shown as a percentage of revenues for that year. Helps to pinpoint problem areas. Uncommon Company Common-Size Income Statement For the Year Ended 12/31/02 Revenues. . . . . . . . . . . . . . . . $10,000 100% Cost of sales. . . . . . . . . . . . 5,000 50 Selling & admin. exp. . . . . . 1,500 15 Income before taxes. . . . . . . . $ 3,500 35% Income tax expense. . . . . . . . 1,000 10 Net income. . . . . . . . . . . . . . . $ 2,500 25%

Learning Objective 5 Complete the closing process in the accounting cycle.

Describe The Closing Process Real Accounts Report the cumulative increases and decreases in balance sheet accounts from the date of organization. Permanent; they are not closed to a zero balance at the period’s end. Balances are carried forward to next period. Nominal Accounts Temporary accounts (revenues, expenses, and dividends) closed to a zero balance at the end of each period. At period’s end, adjustments are made, the income statement is prepared, and balances are then closed to Retained Earnings.

Closing Entries Identify Nominal and Real Accounts nominal or temporary accounts Dec. 31 Sales Revenue. . . . . . . . . . . 1,500 Rent Revenue. . . . . . . . . . . . 100 Cost of Goods Sold . . . . . 1,100 Salaries Expense. . . . . . . 200 Other Expenses . . . . . . . . 150 Retained Earnings . . . . . . 150 real (permanent) account 37

Closing Entries Describe Which Accounts Are Used For Each Entry Step 1. Close all revenue accounts by debiting them. Sales Revenue. . . . . . . . . 15,000 Retained Earnings . . . . 15,000 Step 2. Close all expense accounts by crediting them. Retained Earnings. . . . . . . 13,600 Cost of Goods Sold. . . . 12,800 Insurance Expense. . . . 500 Supplies Expense. . . . . 300 38

Closing the Dividends Account Discuss the Dividends Account a nominal account not expenses distributions to stockholders of part of the corporation’s earnings reduce Retained Earnings are declared and paid To close, credit Dividends and debit Retained Earnings. 40

Make All Three Dividends Entries for $200 Declaration of Dividends: Dividends. . . . . . . . . . . . . . . 200 Dividends Payable . . . . . . 200 Payment of Dividends: Dividends Payable . . . . . . . 200 Cash . . . . . . . . . . . . . . . . 200 Closing Entry for Dividends: Retained Earnings . . . . . . . 200 Dividends . . . . . . . . . . . . 200 43

The Closing Process Retained Earnings Revenues Bal. xxx Beg. Bal. xxx xxx End. Bal. xxx Net income for the period is determined by these two entries. Retained Earnings is a real account and always carries a balance. The dividends account, which is also nominal, is credited to close out the balance. Since the revenues account is a nominal account, it is closed at the end of the period to Retained Earnings. Expenses Bal. xxx xxx The expenses account is also a nominal account and is debited to Retained Earnings to close it. Dividends Bal. xxx xxx 44

Post-Closing Trial Balance Optimal last step. Information taken from the General Ledger after all closing entries are posted. Lists all real account balances at the end of the closing process. 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. 48

Example: Post-Closing Trial Balance Three Monkeys Inc. Post-Closing Trial Balance December 31, 2002 Debits Credits Cash $ 8,200 Accounts Receivable 4,000 Inventory 3,000 Supplies 1,000 Accounts Payable $ 5,000 Capital Stock 10,000 Retained Earnings ______ 1,200 Totals $16,200 $16,200 49

Learning Objective 6 Understand how all the steps in the accounting cycle fit together.

Summary of the Accounting Cycle Financial statements: Result from the accounting cycle. Provide useful information to investors, creditors, and other users. Are included in the annual reports provided to stockholders. Can be analyzed and compared to statements of similar firms to detect strengths and weaknesses.

Learning Objective 7 Expanded Material Make adjusting entries for prepaid expenses and unearned revenues when the original cash amounts are recorded as expenses and revenues.

Example: Prepaid Expenses On July 1, 2002, Time Flies Company pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry using the expense approach? Prepaid Rent Cash Rent Expense Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 Adjusting entry: 12/31/02 Prepaid Rent 1,800 Rent Expense 1,800 22

Example: Prepaid Expenses On July 1, 2002, Pot Of Gold Inc. pays the Rainbow Company $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. Use the revenue approach. Unearned Rent Rent Revenue Cash Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 Adjusting entry: 12/31/02 Rent Revenue 1,800 Unearned Rent 1,800 22

Appendix A: Using a Work Sheet What Is a Work Sheet? A columnar schedule used to summarize accounting data. For internal use only. Helpful for organizing large quantities of data. Most use computer spreadsheets. How Does It Work? First list the trial balance. Then add any adjusting entries. Extend the combined amounts to the appropriate statement columns. Add a balancing figure if debits do not equal credits.

Appendix B: Special Journals Sales Journal Record credit sales at their gross amounts, noting discounts at the time of collection (in the Cash Receipt Journal). Cash Receipts Journal Record all cash received from sales, interest, rent, or other sources. Purchases Journal Record credit purchases. At period’s end, post total to both Accounts Payable and Purchases. Cash Disbursements Journal Record all cash paid out for supplies, merchandise, salaries, and other items.

END CHAPTER 4 "Things which matter most must never be at the mercy of matter least."