Chapter 6 The annual report and accounts The closure of the accounting cycle and Accounting information disclosed to the public 1
Six steps in the accounting cycle 1. Analyze transactions from the source documents 2. Journalize transactions 3. Post entries to the ledger and prepare a trial balance 4. Make end-of-period adjustments and prepare an adjusted trial balance 5. Prepare financial statements 6. Close the accounts and prepare a post-closing trial balance 2
Example A small company named ZiscoSys. The transactions are stated in chronological order: (1) 8.000 Owner s Investment to start up the business (2) Purchase of equipment for 4.000 paid in cash (3) Purchase of supplies on credit for 500 (4) 400 payment of a liability (accounts payable resulting from delivery of supplies) (5) 5.000 revenues earned on credit (6) 3.000 collection of accounts receivable (7) Incurring expenses of 500 for rent and 200 for utility, resp., and Prepaid Insurance of 1.200 (8) reception of a down payment of 2.400 for services to be performed (unearned revenue or deferred revenue), and (9) Owner s withdrawal of 800. 3
Trial Balance ZiscoSys Magdeburg Trial Balance ZiscoSys Magdeburg Trial Balance September 30, 2003 Cash 6.500 Accounts Receivable 2.000 Equipment 4.000 Supplies 500 Prepaid Insurance 1.200 Accounts Payable 300 Unearned Revenue 2.400 Owner's Investment 8.000 Owner's Withdrawal 800 Revenues 5.000 Expenses 700 15.700 15.700 4
Step 1 include all accounts with balances from ledger ZiscoSys Magdeburg Work Sheet For the month ended September 30, 2003 Trial Adjusted Income Balance Balance Adjustments Trial Balance Statement Sheet Account titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 6.500 Accounts Receivable 2.000 Equipment 4.000 Supplies 500 Prepaid Insurance 1.200 Accounts Payable 300 Unearned Revenue 2.400 Owner's Investment 8.000 Owner's Withdrawal 800 Revenues 5.000 Rent Expense 500 Utility Expense 200 Totals 15.700 15.700 5
Step 2 add adjustment data ZiscoSys Magdeburg Work Sheet For the month ended September 30, 2003 Trial Adjusted Income Balance Balance Adjustments Trial Balance Statement Sheet Account titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 6.500 Accounts Receivable 2.000 Equipment 4.000 Supplies 500 200 Prepaid Insurance 1.200 100 Accounts Payable 300 Unearned Revenue 2.400 200 Owner's Investment 8.000 Owner's Withdrawal 800 Revenues 5.000 200 Rent Expense 500 Utility Expense 200 Totals 15.700 15.700 Supplies Expense 200 Insurance Expense 100 Accumulated Depreciation 84 - Office Equipment Depreciation Expense 84 Totals 584 584 6
step 3 combine trial balance amounts with adjustment amounts ZiscoSys Magdeburg Work Sheet For the month ended September 30, 2003 Trial Adjusted Income Balance Balance Adjustments Trial Balance Statement Sheet Account titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 6.500 6.500 Accounts Receivable 2.000 2.000 Equipment 4.000 4.000 Supplies 500 200 300 Prepaid Insurance 1.200 100 1.100 Accounts Payable 300 300 Unearned Revenue 2.400 200 2.200 Owner's Investment 8.000 8.000 Owner's Withdrawal 800 800 Revenues 5.000 200 5.200 Rent Expense 500 500 Utility Expense 200 200 Totals 15.700 15.700 Supplies Expense 200 200 Insurance Expense 100 100 Accumulated Depreciation 84 84 - Office Equipment Depreciation Expense 84 84 Totals 584 584 15.784 15.784 7
step 4 transfer adjusted balances to appropriate statement accounts ZiscoSys Magdeburg Work Sheet For the month ended September 30, 2003 Trial Adjusted Income Balance Balance Adjustments Trial Balance Statement Sheet Account titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 6.500 6.500 6.500 Accounts Receivable 2.000 2.000 2.000 Equipment 4.000 4.000 4.000 Supplies 500 200 300 300 Prepaid Insurance 1.200 100 1.100 1.100 Accounts Payable 300 300 300 Unearned Revenue 2.400 200 2.200 2.200 Owner's Investment 8.000 8.000 8.000 Owner's Withdrawal 800 800 800 Revenues 5.000 200 5.200 5.200 Rent Expense 500 500 500 Utility Expense 200 200 200 Totals 15.700 15.700 Supplies Expense 200 200 200 Insurance Expense 100 100 100 Accumulated Depreciation 84 84 84 - Office Equipment Depreciation Expense 84 84 84 Totals 584 584 15.784 15.784 8
step 5 total statement accounts and compute net income/loss ZiscoSys Magdeburg Work Sheet For the month ended September 30, 2003 Trial Adjusted Income Balance Balance Adjustments Trial Balance Statement Sheet Account titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 6.500 6.500 6.500 Accounts Receivable 2.000 2.000 2.000 Equipment 4.000 4.000 4.000 Supplies 500 200 300 300 Prepaid Insurance 1.200 100 1.100 1.100 Accounts Payable 300 300 300 Unearned Revenue 2.400 200 2.200 2.200 Owner's Investment 8.000 8.000 8.000 Owner's Withdrawal 800 800 800 Revenues 5.000 200 5.200 5.200 Rent Expense 500 500 500 Utility Expense 200 200 200 Totals 15.700 15.700 Supplies Expense 200 200 200 Insurance Expense 100 100 100 Accumulated Depreciation 84 84 84 - Office Equipment Depreciation Expense 84 84 84 Totals 584 584 15.784 15.784 1.084 5.200 14.700 10.584 Net Income 4.116 4.116 Totals 5.200 5.200 14.700 14.700 9
Closing the books... means making accounts ready for the next accounting period... is done at the end of each accounting period Temporary (Nominal) These accounts are closed Permanent (Real) These accounts are not closed All revenue accounts All expense accounts Owner's drawing account All asset accounts All liability accounts Owner's capital account Source: Weygandt/Kieso/Kimmel, p.141 10
Purpose of closing entries zero out all nominal accounts transfer net income (loss) and owner s withdrawal into owner s capital account journalizing and posting closing entries is a required step in the accounting process closing entries are journalized in the general journal and then posted 11
The closing process Debit each revenue account for its balance, and credit Income Summary for total revenues. Credit each expense account for its balance, and debit Income Summary for total expenses. Closing the Income Summary account balance to the Capital account. Closing the Withdrawals account balance to the Capital account. Alternative: close revenue and expense accounts directly to the capital account 12
One example before we go through the whole closing process... let s close the revenue account for ZiscoSys Service Revenue Account Service Revenue Account 5.000 200 5.200 Balance after adjustment but before closing Closing the account on September 30, yields the following 5.000 5.200 200 Closing entry to "zero out" service revenue account 0 13
ZiscoSys accounts before closing Expense Accounts Revenue 1.084 5.200 800 Withdrawals Capital 8.000 14
Closing process for ZiscoSys Expense Accounts Revenue 1.084 5.200 800 Withdrawals Capital 8.000 Income Summary 15
Step 1: close revenue account Expense Accounts Revenue 1.084 5.200 5.200 800 Withdrawals Capital = 8.000 Income Summary 5.200 16
Step 2: close expense accounts Expense Accounts Revenue 1.084 1.084 5.200 5.200 = = Withdrawals Capital 800 8.000 Income Summary 1.084 5.200 17
Step 3: close income summary account Expense Accounts Revenue 1.084 1.084 5.200 5.200 = = Withdrawals Capital 800 8.000 4.116 Income Summary 1.084 4.116 5.200 = 18
Step 4: close withdrawal account Expense Accounts Revenue 1.084 1.084 5.200 5.200 = = Withdrawals Capital 800 800 800 8.000 4.116 = Income Summary 1.084 4.116 5.200 = 19
Preparing a Post-Closing Trial Balance Why?... to prove equality of permanent account balances Post-Closing Trial Balance ZiscoSys Magdeburg Post-Closing Trial Balance September 30, 2003 Cash 6.500 Accounts Receivable 2.000 Equipment 4.000 Supplies 300 Prepaid Insurance 1.100 Accumulated Depreciation - Office Equipment 84 Accounts Payable 300 Unearned Revenue 2.200 Owner's Capital 11.316 13.900 13.900 note that all temporary accounts have zero balances after closing hence, they don t enter the post-closing trial balance 20
Summary of the Accounting Cycle 1 - Analyze transactions from source documents 2 - Journalize transactions 3 -Post entries to ledger Start of a new accounting cycle 4 - Prepare trial balance 5 - Make end-of-period adjusting entries 8 - Close accounts and prepare post-closing trial balance 7 Prepare financial statements 6 -Prepare adjusted trial balance 21
Reversing entries an example employer has a biweekly payroll of 8.000, salaries are paid on the 10th and 24th each month September 24, initial salary entry : 8.000 of salaries earned between September 10 and September 24 are paid. September 30, adjusting entry : salaries earned between September 24 and September 30 amount to 4.000 and will be paid in the October 10 payroll. October 10, subsequent salary entry : salaries paid are 8.000. Of this amount, 4.000 accrued in September as salaries payable and 4.000 was earned in October 22
Illustration of reversing entries No Reversing Entry Initial Salary Entry Sept. 24 Salaries Expense 8.000 Cash 8.000 Adjusting Entry Sept. 30 Salaries Expense 4.000 Salaries Payable 4.000 Closing Entry Sept. 30 Income Summary 12.000 Salaries Expense 12.000 Reversing Entry Used Initial Salary Entry Sept. 24 Salaries Expense 8.000 Cash 8.000 Adjusting Entry Sept. 30 Salaries Expense 4.000 Salaries Payable 4.000 Closing Entry Sept. 30 Income Summary 12.000 Salaries Expense 12.000 Oct. 1 Reversing Entry no reversing entry Reversing Entry Oct. 1 Salaries Payable 4.000 Salaries Expense 4.000 Subsequent Salary Entry Oct. 10 Salaries Payable 4.000 Salaries Expense 4.000 Cash 8.000 Subsequent Salary Entry Oct. 10 Salaries Expense 8.000 Cash 8.000 Adapted from Weygandt/Kieso/Kimmel, p.161 23
Correcting entries needed when errors are discovered correcting entries are journalized and posted whenever an error is detected Wrong entry Correct entry Sept. 20 Cash 3.000 Sept. 20 Accounts Receivable 3.000 Service Revenue 3.000 Service Revenue 3.000 Correcting entry Sept. 20 Accounts Receivable 3.000 Cash 3.000 Balance in cash account is reduced to zero by posting the correcting entry. 24
The contents of financial statements financial statements of (listed) enterprises have common significant subgroups certain minimum requirements for disclosure and audit USA FASB statement of financial accounting concepts 1-6; submission to SEC Europe: IAS 1 (and its revision); EU s 4th Directive Annual report Minimum disclosures Review of past year's results and financial condition Audit requirement None (consistency check Information on with regard to - post-balance sheet events annul accounts) - likely future development - R&D - purchase of own shares Annual accounts Balance sheet Income statement Notes to the accounts Yes 25
1. Balance Sheet Standard balance sheet classifications are: Assets Current assets Fixed assets Property, plant, and equipment Long-term financial investments Intangible assets Liabilities and Owner's Equity Current liabilities Long-term liabilities Owner's (Shareholders' ) equity classification current / non-current required under 4th directive (but not under IAS 1) if not classified, items should be listed in order of liquidity (ascending/descending) 26
Current Assets assets that are expected to be converted into cash within a year or within the normal operating cycle, whichever is longer operating cycle average time to go from cash to cash in producing revenues current assets are listed on the balance sheet in order of their liquidity examples: cash, marketable securities, notes receivable, accounts receivable, inventory, prepaid expenses Example: TimeWarner annual report 2007 Current assets 2007 2006 Cash and equivalents $ 1,516 1,549 Receivables, less allowances of $ 2,410 and $ 2,271 7,296 6,064 Inventories 2,105 1,907 Prepaid expenses and other current assets 834 1,165 Deferred income taxes 700 1,050 Current assets of discontinued operations - 166 Total current assets 12,451 11,901 27
Fixed Assets Long-Term Investments assets that are not expected to be converted into cash within a year not intendend for use or consumption within the company sometimes just labeled investments examples: bonds and stocks of other companies, real estate held for resale Property, Plant, and Equipment tangible, long-lived assets used in production or sale of inventory, or providing of a service examples: land, buildings, and equipment assets that wear out should be reported at cost less accumulated depreciation 28
Intangible Assets assets without physical substance represent legal right of use for a specific period of time examples: patents, copyrights, trademarks, or trade names, goodwill Difference between price paid for an acquisition minus book value of equity Example: TimeWarner annual report 2007 Fixed assets 2007 2006 Noncurrent inventories and film costs $ 5,304 5,394 Investments, including available-for-sale securities 1,963 3,426 Property, plant, and equipment, net 18,048 16,718 Intangible assets subject to amortization 5,167 5,204 Intangible assets subject to amortization 47,220 46,362 Goodwill 41,749 40,749 Other assets 1,928 2,389 Noncurrent assets of discontinued operations - 576 Total fixed assets 121,379 120,818 29
Current Liabilities liabilities that require use of current assets for their payment thus, due within a year or within the next operating cycle examples: accounts payable, wages and salaries payable, unearned revenues, bank loans payable, interest payable current assets current liabilities are assets liquidating during the current period sufficient to cover liabilities due during that period? Current ratio:=? McDonald s carries a current ratio that is less than 50 percent, with relatively little investments in cash, receivables, and prepaid expenses. Explain why McDonald s is not in danger of going bankrupt even though its current liabilities far exceed its current assets. 30
Long term capital Long-Term Liabilities obligations that are due after one year or an operating cycle examples: mortgages payable, bonds payable, lease liabilities Owner s Equity content of owner s equity section depends on form of business organization partnership: one capital account for each partner corporation: capital stock and retained earnings 31
Classified balance sheet for ZyscoSys ZiscoSys Magdeburg Balance Sheet September 30, 2003 Assets Liabilities and Owner's Equity Current Assets Current Liabilities Cash 6.500 Accounts Payable 300 Accounts Receivable 2.000 Unearned Revenue 2.200 Supplies 300 Prepaid Insurance 1.100 Total current liabilities 2.500 Total current assets 9.900 Owner's Equity Net Services, Capital 11.316 Property, Plant, and Equipment Equipment 4.000 Less: Accumulated Depreciation -84 3.916 Total Liabilities and Total Assets 13.816 Owner's Equity 13.816 32
Format of Balance Sheet (EU formats) account format Assets Fixed Assets Current assets Equity and Liabilities Shareholders Equity Long term liabilities and provisions Current liabilities statement format (1) Fixed Assets (2) + current assets (3) - current liabilities (4) net current assets [= (2) (3)] (5) Total assets net of current liabilities [=(1) + (4)] (6) - long term liabilities and provisions (7) = net assets [=(5) (6)] (8) = shareholders equity 33
2 Income Statement Functional basis (vertical layout) (1) Revenue from sales (2) Cost of goods sold (3) = Gross margin (4) Selling and distribution expense (5) Administration expense (6) + other operating income (7) = Operating profit or loss (8) + Investment income (9) Financial expense,net (= interest expense interest income) (10) Income tax (11) = Net profit or loss on ordinary activities (12) +/- Extraordinary gain or loss, net of tax (13) = Net profit or loss for the year 34
Income Statement, retail company natural basis (vertical layout) (1) Revenue from sales (2) + increase decrease in inventories (3) Cost of merchandise and services purchased (4) Personnel expense (5) Depreciation (and asset writedowns) (6) other operating expenses (7) + other operating income (8) = Operating profit or loss (9) + Investment income (10) Financial expense,net (= interest expense interest income) (11) Income tax (12) = Net profit or loss on ordinary activities (13) +/- Extraordinary gain or loss, net of tax (14) = Net profit or loss for the year instead of vertical layout also horizontal layout (account form) admissible for both natural and functional basis 35
Clean vs. dirty surplus accounting Net assets (End of period) net assets (Beginning of period) contributions to equity (receipts from share issues) + dividends + amount used to redeem shares = Comprehensive income usually not equal to income according to income statement difference: change in value of assets and liabilities due to exchange rate changes and other, depending on country s accounting regulations 36