Ch.2 A Review of the Accounting Cycle 1. 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 2-1
1. Basic Steps in the Accounting Process The Recording Phase 1. Business documents are analyzed. 2. Transactions are recorded. 3. Transactions are posted. (continued) 2-2
The Accounting Process The Reporting Phase 4. A trial balance of the accounts in the general ledger is prepared. 5. Adjusting entries are recorded. 6. Financial statements are prepared. 7. Nominal accounts are closed. 8. A post-closing trial balance may be prepared. 2-3
2-4
2. Analyze Transactions and Make and Post Journal Entries Accounting Terminology Transactions are events that transfer or change goods or services between or among two or more entities. Business documents, such as invoices, provide evidence that transactions have occurred as well as the data required to record the transactions in the accounting records. 2-5
Accounting Terminology Double-entry accounting is an old and universally accepted system for recording accounting data. Each transaction is recorded in a way that maintains the equality of the basic accounting equation: Assets = Liabilities + Owners Equity (continued) 2-6
Accounting Terminology A debit is an entry on the left side of an account. A credit is an entry on the right side of an account. Assets, expenses, and dividends are increased by debits and decreased by credits. Liabilities, capital stock, retained earnings, and revenues are increased by credits and decreased by debits. 2-7
Three-Step Journal Entry Process 1. Identify the accounts involved with an event or transaction. 2. Determine whether each account increased or decreased (this information, coupled with the answer to step 1, will tell you if the account was debited or credited). 3. Determine the amount by which each account was affected. 2-8
2-9
(continued) 2-10
2-11
Summarizing 1. Assets are increased by debits and decreased by credits. 2. Liability and owners equity accounts are increased by credits and decreased by debits. 3. Owners equity for a corporation includes capital stock accounts and the retained earnings account. 4. Revenues, expenses, and dividends relate to owners equity through the retained earnings account. (continued) 2-12
Summarizing 5. Expenses and dividends are increased by debits and decreased by credits because they reduce owners equity. 6. Revenues are increased by credits and decreased by debits. 7. The difference between total revenues and total expenses for a period is net income (loss), which increases (decreases) owners equity through the retained earnings account. 2-13
Analyzing Business Documents Normally, a business document, or source document, is the first record of each transaction. The business document provides support for the data to be recorded in the journals. Documents underlying each recorded transaction provide a means of verifying the accounting records and thus form a vital part of the information and control systems. 2-14
Journalizing Transactions Once the information provided on business documents has been analyzed, transactions are recorded in chronological order in the appropriate journal or journals. A special journal is used to record a particular type of frequently recurring transaction. The general journal is used to record all transactions for which a special journal is not maintained. 2-15
Journalizing Transactions 2-16
Posting to the Ledger Accounts An account is used to summarize the effects of transactions on each element of the expanded accounting equation. A ledger is a collection of accounts maintained by a business. The transfer of information from the journal to the appropriate accounts in the ledger is referred to as posting. (continued) 2-17
Posting to the Ledger Accounts 2-18
Establishing Separate Ledgers The general ledger includes all accounts appearing on the financial statements, and separate subsidiary ledgers afford additional detail in support of certain general ledger accounts. The general ledger account that summarizes the detailed information in a subsidiary ledger is known as a control account. 2-19
3. Make Adjusting Entries, Produce Financial Statements, and Close Nominal Accounts Preparing a Trial Balance After all transactions for the period have been posted to the ledger accounts, the balance for each account is determined. A trial balance is a list of all accounts and their balances. It provides a means to assure that total debits equal total credits. (continued) 2-20
(continued) 2-21
2-22
Preparing Adjusting Entries Although the majority of accounts are up to date at the end of the accounting period and their balances can be included in the financial statements, some accounts require adjustment to reflect current circumstances. At the end of each accounting period, in order to report all asset, liability, and owners equity amounts properly and to recognize all revenues and expenses for the period on an accrual basis, accountants are required to make adjusting entries prior to preparing financial statements. 2-23
Steps to Analyze Circumstances 1. Determine whether the amounts recorded for all asset and liabilities is correct. 2. Determine what revenue or expense adjustments are required as a result of the changes in recorded amounts of assets and liabilities indicated in step 1. 2-24
Areas Most Commonly Requiring Analysis Transactions where cash will be exchanged in a future period: 1. Unrecorded assets Assets and revenues that have been earned but not yet recorded. 2. Unrecorded liabilities Expenses and liabilities that have been incurred but not yet recorded. 3. Prepaid expenses Expenses that have been recorded but not yet incurred. 4. Unearned revenues Revenues that have been recorded but not yet earned. (continued) 2-25
Rosi, Inc. 2-26
Unrecorded Assets Revenues should be recorded when earned, regardless of when cash is received. This ensure that all receivables are properly reported on the balance sheet in the correct amounts. The unrecorded receivables are earned and represent amounts that are receivable in the future. (continued) 2-27
Unrecorded Assets (a) If revenue is earned but not yet collected in cash, a receivable exists. Rosi, Inc., has interest on a note receivable of $250. Interest Receivable 250 Interest Revenue 250 To record accrued interest on notes receivable. 2-28
Unrecorded Liabilities Liabilities can be created by expenses being incurred prior to being paid or recorded. Adjusting entries are required at the end of the accounting period to recognize any unrecorded liabilities. (continued) 2-29
Unrecorded Liabilities (b) Rosi, Inc., had unrecorded salaries and wages amounting to $2,150 at the end of the accounting period. Salaries and Wages Expense 2,150 Salaries and Wages Payable 2,150 To record accrued salaries and wages. (continued) 2-30
Unrecorded Liabilities (c) Rosi, Inc., firm accrued interest of $5,000 on a bond payable. Interest Expense 5,000 Interest Payable 5,000 To record accrued interest on bonds. (d) Rosi, Inc., owed federal and state income taxes totaling $8,000. Income Tax Expense 8,000 Income Taxes Payable 8,000 To record income taxes. (continued) 2-31
Prepaid Expenses Payments that a company makes in advance for items normally charged to expense are known as prepaid expenses. An expense is the using up of an asset. The adjusting entry shows the complete consumption of an asset. 2-32
Prepaid Expenses Originally Debited to an Asset Account If the asset account was originally debited, the adjusting entry requires that an expense account be debited for the amount applicable to the current period and the asset account credited. (e) The expired portion of Rosi Inc. s prepaid insurance is $4,200. The following adjusting entry is required: Insurance Expense 4,200 Prepaid Insurance 4,200 To record expired insurance ($8,000 $3,800 = $4,200). (continued) 2-33
Prepaid Expenses Originally Debited to an Expense Account If an expense account was originally debited, the adjusting entry requires that an asset account be debited for the amount applicable to future periods and the expense account be credited. If Rosi Inc., had originally debited Insurance Expense for $8,000, the expense account shows $8,000, but $3,800 is applicable to future periods. The adjusting entry would be as follows: Prepaid Insurance 3,800 Insurance Expense 3,800 To record prepaid insurance ($8,000 $4,200 = $3,800). (continued) 2-34
Prepaid Expenses Originally Debited to an Asset Account The following T-accounts illustrate the effect that this adjusting entry would have on the relevant accounts: Whether the initial debit is made to Prepaid Insurance or Insurance Expense, the ending balances will be the same if the proper adjusting entry is made. 2-35
Unearned Revenues Amounts received before the actual earning of revenues are known as unearned revenues. Because the company has received cash but not yet given the customer the purchased goods or services, the unearned revenues are in fact liabilities. 2-36
Unearned Revenues Originally Credited to a Revenue Account (f) As indicated in the trial balance for Rosi, Inc., rent receipts are recorded originally in the rent revenue account. Unearned revenue at the end of 2013 is $475, and is recorded as follows: Rent Revenue 475 Unearned Rent Revenue 475 To record unearned rent revenue. (continued) 2-37
Unearned Revenues Originally Credited to a Revenue Account The following T-accounts illustrate the effect that this adjusting entry would have on the related accounts. 2-38
Unearned Revenues Originally Credited to a Liability Account If a liability account was originally credited, this account is debited and a revenue account is credited for the amount applicable to the current period. Unearned Rent Revenue 2,075 Rent Revenue 2,075 To record rent revenue ($2,550 $475). (continued) 2-39
Unearned Revenues Originally Credited to a Liability Account The following T-accounts illustrate the effect that this adjusting entry would have on the relevant accounts: 2-40
Transactions Involving Estimates Accountants must constantly use judgment when applying the accrual accounting model. Questions such as how many periods will a machine generate revenues or how many credit customers will not pay must be answered and reflected in the financial statements by using estimations. (continued) 2-41
Transactions Involving Estimates Asset Depreciation Operations are charged with a portion of the asset s cost, and the carrying value of the asset is reduced by that amount. A reduction in an asset for depreciation is usually recorded by a credit to a contra account, which is set up to record subtractions from related accounts. (continued) 2-42
Transactions Involving Estimates Asset Depreciation (g) Rosi Inc., estimated depreciation at the end of the year to be five percent for buildings and ten percent for furniture and equipment. Depreciation Expense Building 7,800 Accumulated Depreciation Building 7,800 To record depreciation on buildings at 5% per year. (continued) 2-43
Transactions Involving Estimates (g) Asset Depreciation Depreciation Expense Furniture & Fixtures 1,900 Accumulated Depreciation Furniture & Fixtures 1,900 To record depreciation on furniture and equipment at 10% per year. 2-44
Bad Debts Invariably, when a business allows customers to purchase goods and services on credit, some of the accounts receivable will not be collected. Under the accrual concept, an adjustment should be made for estimated expense in the current period rather than when specific accounts become uncollectible. (i) Rosi Inc. s estimated Allowance for Bad Debts is to be increased by $1,100. Bad Debt Expense 1,100 Allowance for Bad Debts 1,100 To adjust for estimated bad debt expense. (continued) 2-45
Adjusting Entry Summary Adjusting entries do not involve cash. Adjusting entries always involve a balance sheet account and an income statement account. 2-46
Preparing Financial Statements 1. Identify all revenues and expenses these account balances are used to prepare the income statement. 2. Compute the net income subtract expenses from revenues. 3. Compute the ending Retained Earnings balance. 4. Prepare a balance sheet using the balance sheet accounts from the trial balance and the modified retained earnings balance. 2-47
Using a Spreadsheet An optional step in the accounting process is to use a spreadsheet (also called a work sheet) to facilitate the preparation of adjusting entries and financial statements. The availability of spreadsheet software makes the preparation of a spreadsheet quite easy. A spreadsheet for Rosi, Inc, is shown on the following slides. (continued) 2-48
(continued) 2-49
(continued) 2-50
(concluded) 2-51
Using a Spreadsheet Nominal (or temporary) accounts: Closed to a zero balance at the end of each accounting period. All income statement accounts and the dividend account are closed. Real (or permanent) accounts: Not closed to a zero balance at the end of the accounting period. Carried forward to the next period. 2-52
The Closing Process Revenues xx Bal. xxx Retained Earnings Beg. Bal. xxx Revenues Since the revenue account is a nominal account, it is closed at the end of the period to Retained Earnings. (continued) 2-53
The Closing Process Retained Earnings Expenses Beg. Bal. xxx Revenues Bal. xxx Expenses xx Each expense account is credited in order to close the account at the end of the period. (continued) 2-54
The Closing Process The dividends account, which is also nominal, is credited to close out the balance. Retained Earnings Expenses Dividends Beg. Bal. xxx Revenues Dividends (continued) Bal. xxx x x 2-55
The Closing Process Retained Earnings is a real account and always carries a balance. Retained Earnings Expenses Dividends Beg. Bal. xxx Revenues Net Income for the period is determined by these two items. Dividends reduce Retained Earnings. 2-56
The Closing Process for Rosi, Inc. (continued) 2-57
The Closing Process for Rosi, Inc. 2-58
The Closing Process for Rosi, Inc. 2-59
Post-Closing Trial Balance Provides a listing of all real account balances at the end of the closing process. The post-closing trial balance is prepared to verify the equality of debits and credits for all real accounts. 2-60
Post-Closing Trial Balance (continued) 2-61
Post-Closing Trial Balance 2-62
4. Accrual and Cash-basis Accounting Accrual Accounting Accrual accounting recognizes revenues as they are earned, not necessarily when cash is received. Expenses are recognized as they are incurred, not necessarily when cash is paid. Provides a better basis for financial reporting, according to the FASB. 2-63
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 service companies. 2-64
5. Importance and Expanding Role of Computers to the Accounting Process Computers and Accounting Many steps of the accounting cycle are performed using computers. Typical computerized functions include generating reports and computational analysis. The computer will never replace a good accountant! (continued) 2-65
Computers and Accounting A recent development in the use of computers in financial reporting is the spread of XBRI: Stands for extensible Business Reporting Language. Is a method of embedding computer-readable tags in financial report documents. Allows a company to download its financial statements into spreadsheets where they can be compared to the financial statements of other companies that have also been downloaded. 2-66