The Accounting Cycle

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The Accounting Cycle

• After studying this chapter you should be able
  to
• Understand basic accounting terminology.
• Explain double-entry rules.
• Identify steps in the accounting cycle.
• Prepare adjusting entries.
• Prepare closing entries.
• Prepare reversing entries.

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Roadmap

• Basic terminology
• Introduction to accounting cycles
• Adjusting entries
• Prepayments
• Prepaid expenses
• Unearned revenues
• Accruals
• Accrued revenues
• Accrued expenses
• Closing entries
• Reversing entries

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Basic Terminology

• The following is a brief summary of selected
  terms.
• Event A happening of consequence. May be
  external or internal. Generally triggers a
  change in assets, liabilities or equity.
• Transaction An external event involving a
  transfer or exchange between two or more
  entities.
• Account A systematic recording of transactions
  or events that affect assets, liabilities,
  equity, revenue and expense areas. An account
  represents an area of similar economic interest.

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Basic Terminology

• Real Accounts Balance sheet accounts--Asset,
  liability and equity accounts (except dividends).
  Exist from one period to the next (not closed).

• Nominal Accounts Income statement
  accounts--Revenue and expense as well as the
  dividends account. They do not exist from one
  period to the next (they are closed).

Exist in name only!
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Basic Terminology

• Trial Balance A list of all open accounts in
  the GL and their balances. Done to prove the
  equality of debits and credits.
• Unadjusted--taken after routine entries are
  posted.
• Adjusted--taken after adjusting entries are
  posted.
• Post-closing--taken after closing entries are
  posted.
• Adjusting Entries Done to bring the books up to
  date in anticipation of the preparation of the
  financial statements.
• Financial Statements The primary reporting
  vehicles for accounting information. They are
  the result of the collection, tabulation and
  summation of accounting data. The following four
  statements comprise a complete set of financial
  statements (taken as a whole)

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Basic Terminology

• Balance sheet--Financial condition (position) of
  an enterprise at the end of the period.
• Income statement--Shows the results of operations
  for the period.
• Statement of cash flows--Reports cash activity
  for the period by operating, investing and
  financing flows.
• Statement of retained earnings--Reconciles the
  beginning and ending balances in the owner equity
  account.
• Closing entries Done to zero the nominal
  accounts, formally calculate income or loss and
  update retained earnings.

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Basic Terminology

• Debits and credits
• Debit means entering an amount on the left-hand
  side of an account. It does not mean increase or
  decrease.
• Credit means entering an amount on the right-hand
  side of an account. It does not mean increase or
  decrease.

Account Name
Debit
Credit
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Basic transaction entries

• Purchase
• Cash Purchase
• Dr. Assets (Trucks, Inventory, etc) xxx
• Cr. Cash xxx
• Purchase on account
• Dr. Assets (Trucks, Inventory, etc) xxx
• Cr. Accounts Payable xxx

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Basic transaction entries

• Sell
• Cash Sell
• Dr. Cash xxx
• Cr. Assets xxx
• Sell on account
• Dr. Accounts Receivable xxx
• Cr. Assets xxx

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Basic transaction entries

• Pay Your Dues
• Dr. Accounts Payable xxx
• Cr. Cash xxx
• Collect Your Dues
• Dr. Cash xxx
• Cr. Accounts Receivable xxx
• Pay Dividends
• Dr. Retained Earnings xxx
• Cr. Cash xxx

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Basic Terminology

• Double Entry System of Accounting. A logical
  method for recording transactions. It recognizes
  that there are at least two events or changes for
  each transaction. Debit (or sum of the debits)
  will always equal the credit (or the sum of the
  credits).
• Balance Sheet Equation
• Assets Liabilities Owner Equity
• Assets will always equal the sources of those
  assets. That is, assets belong to either the
  creditors or the owners.

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Summary of Basic Terminology

• Events, transactions and accounts
• Real accounts and nominal accounts
• Financial statements
• Debits and credits
• Basic equation

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Accounting Cycle

• Accounting Cycle
• Identify, analyze and record relevant business
  transactions.
• Both internal and external events.
• Journalizing
• Record of transactions in the journal in formal
  journal entry form. Transactions are recorded
  all in one place in chronological order.

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Accounting Cycle

• Formal journal entry form (If more than one
  debit and/or more than one credit it is called a
  compound entry.)

Date Account name XX Account name XX Account
name XX Explanation

• Posting Routine function of carrying the
  entries from the journal to the ledger.
• Trial balance Listing of accounts and their
  balances in general ledger order (A,L, OE, R, E).
  Done to prove the equality of the debits and
  credits.

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Accounting Cycle

• Adjusting Journal Entries (AJE) Done to bring
  the books up to date so financial statements can
  be prepared.

Types of AJEs Deferrals Accruals
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Accounting Cycle

• After all the adjusting entries have been
  recorded and posted an adjusted trial balance is
  taken.
• This will not detect omissions or errors where
  debits credits. It only determines, after
  adjusting, that total debits credits.
• Financial statements may then be prepared from
  the adjusted balances.

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Adjusting Entries

• Lets review examples of selected AJEs
• Deferral of an expense (prepaids)
• Deferral of a revenue (unearned revenues)
• Accrual of an expense
• Accrual of a revenue

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Adjusting Entries

• Deferral Type of AJE is characterized by a
  previous transaction which must be adjusted
  because it is now the end of the period (time
  period assumption). The transaction is not yet
  complete at the end of the period.
• Example Deferral of an expense.
• Information You are a tenant renting office
  space for 2,000 per month. On November 1, 19X1,
  you prepay six months of rent or 12,000 to your
  landlord. The original entry may have been

11/1 Rent expense 12,000 Cash 12,000
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Adjusting Entries

• Suppose it is now December 31, 19X1, two months
  later. The previous entry must be adjusted. The
  adjusting entry would be

To adjust 12/31 Prepaid Rent 8,000 Rent
Expense 8,000
Note You had to refer back to the original
entry to prepare the correct adjusting entry.
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Adjusting Entries

• This properly reflects, at the end of the period,
  four months of asset remaining and two months of
  expense matched to the period.
• But what if the original entry had been

11/1 Prepaid Rent 12,000 Cash 12,000
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Adjusting Entries

• Then the appropriate adjusting entry would be

To adjust 12/31 Rent Expense 4,000 Prepaid
Rent 4,000
Note You had to refer back to the original
entry to prepare the correct adjusting entry.
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Adjusting Entries

• Example Deferral of an revenue.
• Information You are a publisher selling
  magazines. You collect on 9/1/X1, a total of
  18,000 for the next six months of publications
  (earned evenly). The original entry may have
  been

12/31 Cash 18,000 Earned Revenue 18,000

• It is now 12/31/X1 and the above entry is no
  longer wholly correct. It must be adjusted to
  reflect you have services still to perform.

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Adjusting Entries

• To adjust
• 12/31 Earned Revenues 6,000
• Unearned (Deferred) Revenues 6,000

But what if the original entry had been
To adjust 12/31 Cash 18,000 Unearned
(Deferred) Revenues 18,000
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Adjusting Entries

• It is now 12/31/X1 and the above entry is no
  longer wholly correct. It must be adjusted to
  reflect you have services still to perform. The
  adjusting entry at 12/31/X1 would be

To adjust 12/31 Unearned Revenues 12,000 Ea
rned Revenues 12,000

• The adjusting entry was prepared with the
  original entry in mind. You arrive at 12,000
  of earned revenue and 6,000 of a liability,
  deferred revenues, at the end of the period.

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Adjusting Entries

• Accrual type of adjusting journal entries
• Done to record an as yet unrecorded transaction.
  To accrue or record for the first time.
• No prior transaction to refer back to or update.
• Example Accrual of a revenue
• Information You have performed accounting
  services for a client on December 30, 19X1. The
  services are valued at 300 but you have not
  recorded this yet nor sent a bill. To adjust

12/31 Accounts Receivable 300 Service Revenue
(Earned) 300
Note There will always be a pairing between a
receivable (balance sheet) and a revenue (income
statement) account.
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Adjusting Entries

• Example Accrual of an expense
• Information You had some emergency repair work
  done on 12/31/X1. The plumber states the bill
  will be approximately 3,400. To adjust

12/31 Repair Expense 3,400 Accounts
Payable 3,400
Note There will always be a pairing between an
expense (income statement) and a payable
(balance sheet) account. The final accrual done
will be the tax accrual.
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Adjusting Entries

• Cost allocation type of adjusting journal entry
• To follow matching and divide up cost to current
  and future periods benefited.
• Depreciation, bad debt expense.
• Example You consume the usefulness of your
  building at the rate of 12,000 per year. To
  recognize that the cost has now been consumed
  (now an expense) you depreciate

12/31 Depreciation Expense (I/S) 12,000 Accumu
lated Depreciation (B/S) 12,000
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Closing Entries

• Purposes of Closing Entries
• Calculate COGS under Periodic Inventory System
• Establish Ending Inventory
• Get rid of Begging Inventory and all Purchases
  related accounts
• COGS is a plug-in number
• Reduce the balance of all nominal accounts to
  zero.
• Debit all revenue accounts and credit Income
  Summary
• Credit all expense accounts and debit Income
  Summary
• Close Income Summary to Retained Earnings

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Reversing Entries

• OPTIONAL
• Purpose simplify the recording of transactions
  in the next accounting period
• When at the beginning of the next accounting
  period
• How reverse the adjusting entry made in the
  previous accounting period
• Example P91
• Guidelines are on Page 92-93.