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C H A P T E R . 4. Completing the Accounting Cycle. Learning Objective 1. Describe how accrual accounting allows for timely reporting and a better measure of a company's economic performance. Why Use Accrual Accounting?. Business requires periodic, timely reporting.

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4

Completing the

Accounting Cycle


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Learning Objective 1

  • Describe how accrual accounting allows for timely reporting and a better measure of a company's economic performance.


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Why Use Accrual Accounting?

  • Business requires periodic, timely reporting.

Accrual-basis accounting better measures a firm’s performance that does cash flow data.


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Define the Time Period Concept.

Time Period Concept—the life of a business is divided into distinct and relatively short time periods so the accounting information can be timely, generally 12 months or less.


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Financial Reports

  • Most companies report to stockholders at fiscal year-end.

  • Other reports are issued more frequently, perhaps monthly or quarterly.

  • This frequency of reports forces accountants to use data based on judgments and estimates.

ABC Inc.

Annual Report


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Define Accrual Accounting

  • A system of accounting in which revenues and expenses are recorded as they are earned and incurred, not necessarily when cash is received or paid.

  • Provides a more accurate picture of a company’s profitability.

  • Statement users can make more informed judgments concerning the company’s earnings potential.


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Revenue Recognition

Revenues are recorded when two main criteria are met: What are they?

The earning process is substantially complete

Cash has either been collected or collection is reasonably assured.


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Define The Matching Principle

costs and expenses

  • All costs and expenses incurred in generating revenues must be recognized in the same reporting period as the related revenues.

  • This process of matching expenses with recognized revenues determines the amount of net income reported on the income statement.

related revenues


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Define Cash-Basis Accounting

  • Revenues and expenses are recognized only when cash is received or payments are made.

  • Mainly used by small businesses.

  • Not an accurate picture of true profitability.


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Accrual-Basis Accounting

Revenues earned $48,000 Expenses incurred 31,000 Income $17,000

Cash-Basis Accounting

Cash receipts $41,000

Cash disbursement 28,000

Income $13,000

Example: Accrual- vs. Cash-Basis Accounting

During 2002, Crown Consulting billed its client for $48,000. On December 31, 2002, it had received $41,000, with the remaining $7,000 to be received in 2003. Total expenses during 2002 were $31,000 with $3,000 of these costs not yet paid at December 31. Determine net income under both methods.

Crown Consulting

Reported Income for 2002


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Learning Objective 2

  • Explain the need for adjusting entries and make adjusting entries for unrecorded receivables, unrecorded liabilities, prepaid expenses, and unearned revenues.


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What Are the Steps in the Accounting Cycle?

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to ledger accounts.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare financial statements.

7. Journalize and post closing entries.

8. Balance the accounts and prepare a post-closing trial balance.


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Why DO Adjusting Entries?

  • Adjusting entries are required at the end of each accounting period for accrual-basis accounting, prior to preparing the financial statements.

  • To bring balance sheet accounts current.

  • To reflect proper amounts of revenues and expenses on the Income Statement.


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Adjusting Entries Tips

  • Each adjusting entry always involves at least one income statement account and one balance sheet account.

Adjusting entries never involve cash.


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Unrecorded Receivables

Unrecorded Liabilities

Prepaid Expenses

Unearned Revenues

Revenues earned but not yet recorded by period’s end.

Expenses incurred but not yet recorded by period’s end.

Payments made in advance for items normally charged to expense.

Amounts received before the actual earning of revenues.

Always debit a Receivable & credit a Revenue for unrecorded receivables

Always debit an Expense & credit a Liability for unrecorded liabilities

Unrecorded Receivables & Liabilities will have no original entries.

Define Each of These Common Adjusting Entries


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What Is the 3-Step Process forAdjusting Entries?

  • 1. Identify the original entries that were made (original entries are only made for unearned revenues and prepaid expenses).

  • 2. Determine what the correct balances should be at this point in time.

  • 3. Make the adjustments needed to correct the balances.


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Rent Receivable

Rent Revenue

Original entry none none

Correct balances 500 500

Adjusting entry:12/31/02 Rent Receivable 500

Rent Revenue 500

Example: Unrecorded Receivables

Bullseye Management earns a rent revenue of $500 in 2002 but will not receive the payment until January 10, 2003. An adjustment will be needed. What is the adjusting entry?


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Property Tax

Expense

Property Tax Payable

Original entry none none

Correct balances 1,000 1,000

Adjusting entry:12/31/02Property Tax Expense 1,000 Property Tax Payable 1,000

Example: Unrecorded Liabilities

MoneyTree Inc. is assessed property taxes of $1,000 for 2002, but will not make this payment until January 5, 2003. An adjustment will be needed. What is the adjusting entry?


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Rent Expense

Prepaid Rent

Cash

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

Adjusting entry:12/31/02 Rent Expense 1,800 Prepaid Rent 1,800

Example: Prepaid Expenses

On July 1, 2002, I Think I Can Inc. pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed.What is the adjusting entry?


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Unearned Rent

Rent Revenue

Cash

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

Adjusting entry:12/31/02 Unearned Rent 1,800 Rent Revenue 1,800

Example: Unearned Revenues

On July 1, 2002, Clean As A Whistle Co. received $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry?


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Learning Objective 3

  • Explain the preparation of the financial statements, the explanatory notes, and the audit report.


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Review The Steps in the Accounting Cycle

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to ledger accounts.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare financial statements.

7. Journalize and post closing entries.

8. Balance the accounts and prepare a post-closing trial balance.


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PreparingFinancial Statements

  • Prepared directly from the data in the adjusted ledger accounts.

  • Explanatory notes clarify the methods and assumptions.

  • The auditor reviews the statements with GAAP.


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What Are The Notes and Why Have Them?

  • List assumptions and methods used in preparing financial statements.

  • Give more detail about specific items.

  • Serve to augment the summarized, numerical information.


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Tell Me About The Audit

  • Audits statements to check conformity with GAAP.

  • Reviews adjustments.

  • Samples selected accounts.

  • Reviews accounting systems.

  • Attaches report and distributes it with financial statements.


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Learning Objective 4

  • Perform a systematic analysis of financial statements.


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What Does The DuPont Framework Do?

  • Summarizes the financial health of a company.

  • Systematic approach for breaking down ROE into three ratios:

  • 1. Profit margin (measure of profitability)

  • 2. Asset turnover (measure of efficiency)

  • 3. Assets-to-equity ratio (measure of leverage)


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Net Income

Equity

Return on Equity =

Profitability x Efficiency x Leverage

Asset Assets-to-

Turnover Equity Ratio

x

x

Profit Margin

Net Income x Revenue x Assets

Revenue Assets Equity

What Are the Components of ROE?


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Uncommon Company

Common-Size Income Statement

For the Year Ended 12/31/02

Revenues. . . . . . . . . . . . . . . . $10,000 100%

Cost of sales. . . . . . . . . . . . 5,000 50

Selling & admin. exp. . . . . . 1,50015

Income before taxes. . . . . . . . $ 3,500 35%

Income tax expense. . . . . . . . 1,00010

Net income. . . . . . . . . . . . . . . $ 2,50025%

Common-Size Financial Statements

  • Divide all financial statement numbers for a given year by the total revenues for the year.

  • All amounts are then shown as a percentage of revenues for that year.

  • Helps to pinpoint problem areas.


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Learning Objective 5

  • Complete the closing process in the accounting cycle.


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Real Accounts

Report the cumulative increases and decreases in balancesheet accounts from the date of organization.

Permanent; they are not closed to a zero balance at the period’s end.

Balances are carried forward to next period.

Nominal Accounts

Temporary accounts (revenues, expenses, and dividends) closed to a zero balance at the end of each period.

At period’s end, adjustments are made, the income statement is prepared, and balances are then closed to Retained Earnings.

Describe The Closing Process


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nominal or

temporary

accounts

real (permanent) account

Closing Entries Identify Nominal and Real Accounts

Dec. 31 Sales Revenue. . . . . . . . . . . 1,500

Rent Revenue. . . . . . . . . . . . 100

Cost of Goods Sold . . . . . 1,100

Salaries Expense. . . . . . . 200

Other Expenses . . . . . . . . 150

Retained Earnings . . . . . . 150


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Closing Entries Describe Which Accounts Are Used For Each Entry

Step 1. Close all revenue accounts by debiting them.

Sales Revenue. . . . . . . . . 15,000

Retained Earnings . . . . 15,000

Step 2. Close all expense accounts by crediting them.

Retained Earnings. . . . . . . 13,600

Cost of Goods Sold. . . . 12,800

Insurance Expense. . . . 500

Supplies Expense. . . . . 300


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Closing the Dividends Account EntryDiscuss the Dividends Account

  • Dividends

    • a nominal account

    • not expenses

    • distributions to stockholders of part of the corporation’s earnings

    • reduce Retained Earnings

    • are declared and paid

  • To close, credit Dividends and debit Retained Earnings.


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Make All Three Dividends Entries for $200 Entry

Declaration of Dividends:

Dividends. . . . . . . . . . . . . . . 200

Dividends Payable . . . . . . 200

Payment of Dividends:

Dividends Payable . . . . . . . 200

Cash . . . . . . . . . . . . . . . . 200

Closing Entry for Dividends:

Retained Earnings . . . . . . . 200

Dividends . . . . . . . . . . . . 200


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Retained EntryEarnings

Revenues

Retained Earnings is a real account and always carries a balance.

xxx

Bal. xxx

The dividends account, which is also nominal, is credited to close out the balance.

Beg. Bal. xxx

Expenses

Revenues

Dividends

End. Bal. xxx

Since the revenues account is a nominal account, it is closed at the end of the period to Retained Earnings.

The expenses account is also a nominal account and is debited to Retained Earnings to close it.

Expenses

Dividends

Net income for the period is determined by these two entries.

xxx

xxx

Bal. xxx

Bal. xxx

The Closing Process


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Post-Closing Trial Balance Entry

  • Optimal last step.

  • Information taken from the General Ledger after all closing entries are posted.

  • Lists all real account balances at the end of the closing process.

  • Assures that total debits equal total credits prior to the beginning of the new accounting period.

  • Only real accounts will have a balance at this time.


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Example: Post-Closing EntryTrial Balance

Three Monkeys Inc.

Post-Closing Trial Balance

December 31, 2002

Debits Credits

Cash $ 8,200

Accounts Receivable 4,000

Inventory 3,000

Supplies 1,000

Accounts Payable $ 5,000

Capital Stock 10,000

Retained Earnings ______ 1,200

Totals $16,200 $16,200


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Learning Objective 6 Entry

  • Understand how all the steps in the accounting cycle fit together.


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Summary of the EntryAccounting Cycle

  • Financial statements:

  • Result from the accounting cycle.

  • Provide useful information to investors, creditors, and other users.

  • Are included in the annual reports provided to stockholders.

  • Can be analyzed and compared to statements of similar firms to detect strengths and weaknesses.


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Learning Objective 7 EntryExpanded Material

  • Make adjusting entries for prepaid expenses and unearned revenues when the original cash amounts are recorded as expenses and revenues.


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Example: Prepaid Expenses Entry

On July 1, 2002, Time Flies Company pays $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. What is the adjusting entry using the expense approach?

Prepaid Rent

Cash

Rent Expense

Original entry 3,600 3,600

Adjusting entry 1,8001,800

Correct balances 1,800 1,800

Adjusting entry:12/31/02 Prepaid Rent 1,800 Rent Expense 1,800


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Unearned Rent Entry

Rent Revenue

Cash

Example: Prepaid Expenses

On July 1, 2002, Pot Of Gold Inc. pays the Rainbow Company $3,600 for one year’s rent in advance (covering July 1, 2002, to June 30, 2003). On December 31, 2002, an adjustment will be needed. Use the revenue approach.

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

Adjusting entry:12/31/02 Rent Revenue 1,800 Unearned Rent 1,800


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Appendix A: Using a Work Sheet Entry

How Does It Work?

First list the trial balance.

Then add any adjusting entries.

Extend the combined amounts to the appropriate statement columns.

Add a balancing figure if debits do not equal credits.

  • What Is a Work Sheet?

  • A columnar schedule used to summarize accounting data.

  • For internal use only.

  • Helpful for organizing large quantities of data.

  • Most use computer spreadsheets.


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Appendix B: Special Journals Entry

Sales Journal

Record credit sales at their gross amounts, noting discounts at the time of collection (in the Cash Receipt Journal).

Cash Receipts Journal

Record all cash received from sales, interest, rent, or other sources.

Purchases Journal

Record credit purchases. At period’s end, post total to both Accounts Payable and Purchases.

Cash Disbursements Journal

Record all cash paid out for supplies, merchandise, salaries, and other items.


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"Things which Entry

matter most

must never

be at the

mercy of

things which

matter least."

END CHAPTER 4


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