Chapter 2: Review of the Accounting Process Part 3: Accounting Cycle with Emphasis on Year End Activities Intermediate Accounting 1 Dr. Chula King Learning Outcomes After completing this part, you should understand How to prepare a trial balance Accrual and deferred/prepaid adjusting entries How to prepare an adjusted trial balance The basic financial statements How to prepare closing entries When reversing entries are appropriate. The Basic Accounting Cycle Transaction or event Journalize Post Unadjusted Trial Balance Adjusting Entries Adjusted Trial Balance Prepare Financial Statements Closing Post Closing Trial Balance Reversing Entries 1
Unadjusted Trial Balance Listing of all accounts and their respective balances Debits = Credits Cannot assume that all transactions and events have been recorded and posted Cannot assume that the accounts and/or amounts are correct. For Example Debit Credit Cash 5,000 Accounts Receivable 1,000 Equipment 10,000 Accounts Payable 3,000 Common Stock 4,000 Retained Earnings 9,000 16,000 16,000 Adjusting Entries: Cash vs. Accrual Basis Cash Basis Revenue is recognized when received Expense is recognized when paid Accrual Basis Revenue is recognized when realized or realizable and when earned Expense is recognized when incurred matching From Transactions to Financial Statements 2
Adjusting Entries Does every item appearing in the trial balance reflect what it should? Are there transactions or events that have occurred that have not been recorded? Are there transactions or events that have been recorded that should not have been? Accruals Revenue earned, but not yet received Receivable xxx Revenue xxx For example, I have an investment of $10,000 in bonds that pay 12% interest every March 1. On December 31, I have earned interest for 10 months, but will not receive it until March 1. Interest Receivable 1,000 Interest Revenue 1,000 Accruals Expense incurred, but not yet paid Expense xxx Payable xxx For example, on December 31, my employees have earned $20,000, that will be paid on January 4 Wage expense 20,000 Wages Payable 20,000 3
Deferred/Prepayments Revenue Revenue received, but not yet earned On December 1, I received $3,000 rent in advance for the three month period beginning on December 1. 12/1 12/31 1/31 2/28 Analysis 1,000 Earned 2,000 Unearned 3,000 Total Balance Sheet Approach Transaction Entry: Cash 3,000 Unearned Rent 3,000 Adjusting entry records the earned portion Adjusting Entry: Unearned Rent 1,000 Rent Revenue 1,000 4
Income Statement Approach Transaction Entry: Cash 3,000 Rent Revenue 3,000 Adjusting entry records the unearned portion. Adjusting Entry: Rent Revenue 2,000 Unearned Rent 2,000 Prepayments Expense Expense paid, but not yet incurred On December 1, I pay $3,000 for insurance that covers the three month period beginning on December 1. 12/1 12/31 1/31 2/28 Analysis 1,000 Expired 2,000 Unexpired 3,000 Total 5
Balance Sheet Approach Transaction Entry: Prepaid Insurance 3,000 Cash 3,000 Adjusting entry records the expired portion Adjusting Entry: Insurance Expense 1,000 Prepaid Insurance 1,000 Income Statement Approach Transaction Entry: Insurance Expense 3,000 Cash 3,000 Adjusting entry records the unexpired portion Adjusting Entry: Prepaid Insurance 2,000 Insurance Expense 2,000 Accruals versus Prepayments Accruals Adjusting entry always precedes Transaction entry Receivable and Revenue; or Expense and Payable. 6
Accruals versus Deferred/Prepayments Deferred/Prepayments Transaction entry always precedes Adjusting entry Balance Sheet Approach: Transaction recorded in balance sheet account; adjust the expired or earned portion Income Statement Approach: Transaction recorded in income statement account; adjust the unexpired or unearned portion. Allocation Entries Technically a prepayment using the balance sheet approach Depreciation and amortization allocate the cost of long lived assets over their useful lives. Adjusted Trial Balance Combines the beginning trial balance with all adjusting entries. 7
Financial Statements Income Statement Statement of Comprehensive Income Balance Sheet Statement of Cash Flows Statement of Shareholders Equity Closing Entries Permanent Accounts (Real) Assets, Liabilities, Equity Temporary Accounts (Nominal) Revenues, Expenses, Gains, Losses, Dividends Close all Income Statement accounts to Income Summary Close Income Summary to Retained Earnings Close Dividends to Retained Earnings Income Summary Expenses and Losses Revenues and Gains Income Summary Income Summary Retained Earnings Retained Earnings Dividends Closing Entries 8
Post Closing Trial Balance Ensures that debits and credits are equal Consists only of real or balance sheet accounts. Reversing Entries Purpose is to simplify the bookkeeping Accrual Basis Cash Basis Reverse all adjusting entries that increase an asset or a liability Reverse all accruals Reverse all prepayments where the income statement approach was used. For Example (A) Salary Expense 1,000 Salary Payable 1,000 (R) Salary Payable 1,000 Salary Expense 1,000 (A) Interest Receivable 1,500 Interest Revenue 1,500 (R) Interest Revenue 1,500 Interest Receivable 1,500 9
For Example (A) Prepaid Insurance 500 Insurance Expense 500 (R) Insurance Expense 500 Prepaid Insurance 500 (A) Insurance Expense 500 Prepaid Insurance 500 (R) NO Reversing Entry... Concluding Comments Transaction or event Journalize Post Unadjusted Trial Balance Adjusting Entries Adjusted Trial Balance Prepare Financial Statements Closing Post Closing Trial Balance Reversing Entries Exercises 1, 2, 3, 7, 8, 9, 10, 12, 15, 19 Problems 3, 5, 7, 8, 10, 11 Next Step 10