1. 4
C H A P T E R
Completing the
Accounting Cycle

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

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

4. 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

5. 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

6. 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

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

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

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

10. 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 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 ,000 Income $17,000
Cash-Basis Accounting
Cash receipts $41,000
Cash disbursement 28,000
Income $13,000 14

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

12. 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

13. 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

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

15. 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.

16. 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

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

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

19. 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 , ,600
Adjusting entry , ,800
Correct balances 1, ,800
Cash
Adjusting entry: 12/31/02 Rent Expense 1, Prepaid Rent ,800 22

20. 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 , ,600
Adjusting entry , ,800
Correct balances , ,800
Adjusting entry: 12/31/02 Unearned Rent , Rent Revenue ,800 22

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

22. 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

23. 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.

24. 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.

25. 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.

26. Learning Objective 4
Perform a systematic analysis of financial statements.

27. 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)

28. 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

29. 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, %
Cost of sales ,
Selling & admin. exp ,
Income before taxes $ 3, %
Income tax expense ,
Net income $ 2, %

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

31. 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.

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

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

34. 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

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

36. 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

37. 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

38. 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 ______ ,200
Totals $16,200 $16,200 49

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

40. 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.

41. 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.

42. 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 , ,600
Adjusting entry 1, ,800
Correct balances 1, ,800
Adjusting entry: 12/31/02 Prepaid Rent , Rent Expense ,800 22

43. 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
Correct balances , ,800
Adjusting entry: 12/31/02 Rent Revenue , Unearned Rent ,800 22

44. 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.

45. 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.

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