Week 2, Completing the accounting cycle. 1/5

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1 Week 2 Horngren, Chapter 4, including the appendix, Completing the accounting cycle. In this chapter we will be using the full accounting worksheet to complete the accounting cycle. The learning objectives are to: Prepare an accounting worksheet Use the worksheet to complete the accounting cycle, Close the temporary accounts, namely the revenue, expense and drawings accounts, Prepare reversing entries, Classify assets and liabilities as current or non-current, And use the current and debt ratios to evaluate a business The Accounting Cycle is the process by which businesses produce a set of financial statements for a particular period of time. With a brand new business this will start with setting up new ledger accounts. With existing businesses the process will start with last year s closing balances being brought forward as this year s opening balances. There are two parts to the cycle, journalising and posting during the year and adjusting, closing, trial balance extraction and accounts preparation at the end of the year. A worksheet is a useful tool which will enable the accountant to summarise and move data from the trial balance to the final financial statements. The worksheet is not part of the double entry system but is merely an aid to the production of the accounts. The accountant can extract balances from the general ledger accounts to prepare an unadjusted trial balance. This then provides a snapshot of the business and helps to identify those accounts that need adjusting. The adjustments are entered and an adjusted trial balance is prepared. It is then possible to get a good idea of how the financial statements will look when completed. Errors and omissions can be corrected easily at this stage. Management can produce a worksheet every week/month without the need to produce a full set of accounts in order to calculate the net profit or loss for the period. A good worksheet will have the accounts listed in the chart of accounts order that will appear in the financial statements. When you prepare a worksheet, start with the far left column and work to the right, making sure that each column is totalled as it is completed before moving to the next column. After the adjustments are completed, and the columns balance, prepare the adjusted trial balance. This has every account, except one, that you will need to prepare a set of financial accounts. The next stage is to transfer the adjusted assets, liability and equity account balances into the balance sheet columns, and to transfer the adjusted revenue and expense account balances into the Income Statement columns. Each account will appear in either the income statement or the balance sheet columns but not both. Exhibit 4-5 illustrates this. You will notice that the income statement columns will not balance, and that neither will the balance sheet columns. This is the missing final account which will be either a net profit or a net loss. If the income statement credit column, containing revenue items, is 1/5

2 greater than the debit column, containing expenses, then the difference will be the net profit, which will be entered at the bottom of the debit column of the income statement. It will also be the balancing figure which must be entered at the bottom of the credit column of the balance sheet, thereby increasing owner s equity. If you have more debits in the income statement than credits, then you will have a net loss and this figure must be entered in the credit column of the income statement and it will also be entered in the debit column of the balance sheet. Have a good look at all the exhibits, starting with Exhibits 4-1 on page 153, through to Exhibit 4-6 on page 156 and work your way through the steps as stated in the text on pages 152 to 158 and follow them through in the exhibits and the summary problem on pages 158 & 159. You will appreciate that we have listed in the income statement columns all that we need to complete an Income Statement, and that we also have in the balance sheet columns all that we need to complete a Balance Sheet. You can take the data from Exhibit 4-6 on page 156 and put it into the statements in Exhibit 4-7 on page 160. However although you are able to produce a set of financial statements in this way if you were to extract the accounting balances from the General Ledger you would NOT get the same data. The reason is that all of the adjustments have been entered in the worksheet which is not part of the double entry system. We have to make certain that for every adjustment that we have made in the worksheet we have journalised the adjusting entries and then we have posted them to the General Ledger. Have a look at Exhibit 4-1, page 153. This hasn t completed the story yet as we don t have a figure for the net profit anywhere in the general ledger, and we still have all the temporary accounts open that will need to be emptied before we can start recording next period s data. This is done by closing the temporary accounts. These are the accounts that record all the expenses, revenues and drawings for the period. The expense accounts need to be matched against the revenue accounts to produce a net profit or a net loss, which in turn needs to be transferred to owner s equity along with the drawings account. By closing the temporary accounts the only accounts that will remain will be the permanent accounts that contain the balances that appear on the balance sheet and will be carried down as the opening balances in the next period. The expenses and revenue accounts are closed into the Income Summary Account and the balance, a net profit or a net loss will then be closed into the Owner s Capital Account. Drawings will also be closed into the Owner s Capital Account. These entries must be journalised and posted. Have a look at Exhibit 4.9 on page 162 and then follow the steps through pages 162 to 164 and look at Exhibit Once that process is completed it is a good idea to extract another Trial Balance called the Post-closing Trial Balance. This ensures that we have correctly adjusted and closed the books and we can be confident that the opening balances for the next period are correct. Only permanent accounts will appear in this trial balance. See Exhibit 4-11, page /5

3 Assets and Liabilities are classified according to their liquidity which is a measure of how quickly they can be converted into cash. We show the most liquid assets first. Current Assets are those assets which we expect to be converted into cash, sold or consumed within the next twelve months or within the business operating cycle if longer. The operating cycle is the length of time that starts when goods and services are acquired, they are then processed and sold to customers, and we then collect cash from our customers. Examples of Current Assets are Cash, Accounts Receivable, Short Term Bills Receivable, Inventory and prepaid expenses. Non-current assets are all other assets and include Land, Buildings, Plant, Equipment, Furniture and Fittings, and Long Term Bills Receivable. Current liabilities are debts or obligations that are due to be paid with cash, goods or services within one year or within an operating cycle if longer. Examples include Accounts Payable, Short Term Bills Payable, Salary Payable, Unearned Revenue, and Interest Payable. Non-current liabilities are all liabilities that are not current liabilities and include, Long Term Bills Payable, ie in more than one year, Bonds Payable, and Mortgages Payable. Have a good look at Exhibit 4-12 on page 166 and the classified balance sheet of Woolworth s on page 168, Exhibit You will need to become familiar with the terms used and the places that these items appear in the balance sheet. Current and debt ratios can be used to evaluate a business. Banks and organisations considering whether to grant credit to the business need to be able to assess whether any loan repayments can be made as and when they fall due. The current ratio compares current assets and current liabilities to assess whether the business will be able to pay current liabilities from current assets. Current ratio = Current assets/current liabilities This ratio is expressed as the number of times current assets cover current liabilities. For example, if current assets are $66,500 and current liabilities are $35,000, then the current ratio can be expressed as 1.9 times or 1.9:1. So for every $1 of current liabilities there is $1.90 of current assets to cover them. The excess of current assets and current liabilities is called the working capital. You must have enough to satisfy the immediate needs of the business, but too much would indicate that there are spare resources which are not generating returns. All assets within the business should be used efficiently and effectively. There needs to be a proper balance. 3/5

4 In some accounting texts the ideal current ratio is 2:1 or 2 times. This, however, fails to take into account the nature of the industry that the business operates in. A supermarket will have a low ratio because it will sell only for cash and as a result it will not have debtors. Inventory will be turning over quickly and this will affect the size of the inventory that is held by the business. There will not be a large amount at any given point of time, but it will take a credit period from its suppliers. Consequently it can buy goods on credit, sell them, receive cash for them and still have 30 days credit before the debt has to be settled. Compare this with a manufacturing business, which will have a high ratio. There will be inventories of raw materials, part processed work-in-progress, and finished goods which will normally be sold on credit, and there will also be debtors. Again what is important is to compare the current ratio for this year with that of last year, look at the trends. Look at industry averages and look at the industry leader. Management, of course, wouldn t wait for twelve months to make a comparison. It would happen at least monthly and frequently weekly. Debt ratio = Total liabilities/total assets x 100 The debt ratio shows the ratio of the total liabilities to total assets to measure the ability of the business to pay both current and non-current liabilities. It gives the user of the financial statements the proportion of the business s assets that are financed with debt. By borrowing, the business will have to service the debt by paying interest and will also have to repay the principal of the loan. This means that there must be sufficient profit to cover the interest and sufficient cash, not only to pay the interest, but also to repay the loan as and when the instalments become due. The larger the proportion of debt to total funding, then the greater the risk and the larger the interest payments. The loan providers will want some form of security for their loan and, besides a seat on the board of directors, they may also have restrictive covenants built into the loan contract. This means that they can demand that the business generate a sufficient level of profit to cover the interest, for example, 3 times, and that the business maintains its assets so that their value is always twice that of liabilities. Failure to do so could result in the loan becoming repayable immediately. So, the greater the loan, the greater the risk. If that was the case, why would any firm borrow funds with which to finance the business? Besides the inability to generate the funds internally and the need for finance, it makes sense from a tax perspective. Payments to the owners of a business, either in drawings or dividends paid to shareholder, are not tax deductible. This means that they have to be paid out of post tax profits and the amounts paid as a percentage of total funds provided by the owners will be high, as the owners will demand a higher return on their investment as their risk is higher. 4/5

5 Conversely money borrowed from a bank will attract rates of interest that would be lower than the returns demanded by owners, and because the money had been borrowed for business purposes it will be tax deductible so it can be paid out of pre-tax profits. Borrowing from outsiders is a cheaper form of finance than obtaining it from the owners. Again there is a need for balance. No borrowing and the business isn t making the most of its debt capacity, too much and it is in danger of not complying with the terms of the loan and could find itself being wound up. Again it does depend on the general economic climate, the industry, and the product life cycle, but a business could safely borrow between 40 to 80 percent of total funding from outsiders. Have a look at page 169 and 170 Work through the summary problem on pages 172 to 175. If you look at the Appendix on pages 191 and 192 you will notice that adjusting entries that deal with accruals are reversed. There is no requirement to do this under the Accounting Standard regulations. These are merely a practical assistance to make life easier when the accrued income is received or the accrued expense is finally paid. If you look at the example of the salary payable of $950, the original adjustment increases the salary expense by debiting the expense account and increases liabilities by crediting the salary payable account. When the expense account is closed at the end of the year the salary expense than has a balance of zero and the salary payable, being a liability account is carried down to the next year. What happens when the next salary payment of $1050 is made from the cash at bank account? The cash at bank is credited with the reduction in the asset cash of $1050. The accountant then has to remember to split the payment into two. One part is to settle the liability of $950 in salary payable and the remaining $100 then has to be debited to this new financial year s salary expense account. Just imaging having to check every single time that a cash payment is made at the beginning of the new financial year whether there is an accrual outstanding in a payable account. It is much simpler just to reverse the original accrual adjustment, by taking the credit balance from salary payable and putting it in the salary expense account. That way when any cash payments are made and the expense account is debited, the first part of the payment is offset against last year s outstanding payable, leaving only the current year s expense in the account. Rather thank having to check every time that a payment is made, you can reverse all the accrual adjustments on the first day of the new financial year and then not have to worry about apportioning the payment whenever payments are made. Please attempt the tutorial exercises as stated in the Unit Outline, Ch4 S4-9, 4-11, E4-10, P4-1 5/5