Chapter 4. Completing the Accounting Cycle. Albrecht, Stice, Stice, Swain

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1 Chapter 4 Completing the Accounting Cycle Albrecht, Stice, Stice, Swain COPYRIGHT 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1

2 Periodic Reporting Beginning of Year Fiscal Year 12-month accounting period. Calendar Year End of Year When an entity closes its books on December 31. 2

3 Accrual Accounting What do we do when transactions span more than one period? Accrual Accounting! Revenues and expenses are recorded as they are earned and incurred, not necessarily when cash is received or paid. Better measures a firm s performance than does cash flow data. 3

4 Revenue Recognition Recognize revenue when: 1. The earning process is substantially complete. 2. Cash has either been collected or collection is reasonably assured. 4

5 The Matching Principle All costs and expenses incurred in generating revenues must be recognized in the same reporting period as the related revenues. If revenues are recognized. Related costs and expenses should be recognized. 5

6 Example: Accrual- vs. Cash- Basis Accounting During 2009, Bond Consulting billed its client for $48,000. On December 31, 2009, it had received $41,000, with the remaining $7,000 to be received in Total expenses during 2009 were $31,000 with $3,000 of these costs not yet paid at December 31. Determine net income under both methods. Cash-Basis Accounting Cash receipts $41,000 Cash disbursement 28,000 Income $13,000 Bond Consulting Reported Income for 2009 Accrual-Basis Accounting Revenues earned $48,000 Expenses incurred 31,000 Income $17,000 6

7 Adjusting Entries Entries required at the end of each accounting period to adjust the accounts to their proper amounts. Unrecorded receivables. Unrecorded liabilities. Prepaid expenses. Unearned revenues. Each adjusting entry involves at least one income statement account and one balance sheet account. 7

8 Example: Unrecorded Receivables Precision Management earns rent revenue of $500 in 2009 but will not receive the payment until January 10, An adjustment will be needed. What is the adjusting entry? Rent Receivable Rent Revenue Original entry none none Correct balances /31/09 Rent Receivable 500 Rent Revenue 500 8

9 Example: Unrecorded Liabilities Protege Inc. is assessed property taxes of $1,000 for 2009, but will not make this payment until January 5, An adjustment will be needed. What is the adjusting entry? Property Tax Expense Property Tax Payable Original entry none none Correct balances 1,000 1,000 12/31/09 Property Tax Expense 1,000 Property Tax Payable 1,000 9

10 Example: Prepaid Expenses On July 1, 2009, Apex Inc. pays $3,600 for one year s rent in advance (covering July 1, 2009, to June 30, 2010). On December 31, 2009, an adjustment will be needed. What is the adjusting entry? Prepaid Rent Cash Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 Rent Expense 12/31/09 Rent Expense 1,800 Prepaid Rent 1,800 10

11 Example: Unearned Revenues On July 1, 2009, Dahl House Co. received $3,600 for one year s rent in advance (covering July 1, 2009, to June 30, 2010). On December 31, 2009, an adjustment will be needed. What is the adjusting entry? Rent Revenue Cash Unearned Rent Original entry 3,600 3,600 Adjusting entry 1,800 1,800 Correct balances 1,800 1,800 12/31/09 Unearned Rent 1,800 Rent Revenue 1,800 11

12 Preparing Financial Statements Four step process using the trial balance: 1. Identify all revenue and expense accounts and prepare the income statement. 2. Compute net income. 3. Compute the ending retained earnings balance. 4. Prepare a balance sheet using the balance sheet accounts and the ending retained earnings balance computed from step 3. 12

13 The Notes and the Audit Notes List assumptions and methods used in preparing the financial statements. Give more detail about specific items. Augment the summarized numerical information. The Audit Check financial statements for conformity with GAAP. Review Adjustments, sample selected accounts, and review accounting systems. Attaches audit report and distributes it with the financial statements. 13

14 Real vs. Nominal Accounts Real Accounts Permanent Not closed at year end. Balance Sheet accounts Balances are carried forward to next period. Nominal Accounts Temporary Closed (brought to a zero balance) at year end. Income Statement accounts and dividends Balance are NOT carried forward to next period. 14

15 The Closing Process The Closing Process Record entries that reduce all nominal accounts to a zero balance at the end of the accounting period. Nominal accounts are closed to retained earnings. Revenues xxx Bal. xxx Expenses Bal. xxx xxx Retained Earnings Beg. Bal. xxx Revenues Expenses 15

16 Closing Entries Step 1: Close all revenue accounts by debiting them. Step 2: Close all expense accounts by crediting them. Step 3: The difference between revenues and expenses (net income) should be credited to retained earnings. Revenues XXX Cost of Goods Sold Other Expenses Retained Earnings XXX XXX XXX 16

17 Dividends Nominal account but NOT an expense. Distribution to shareholders. Closed by crediting dividends and debiting retained earnings (reduces retained earnings). When dividends are first declared: Dividends XXX Dividends Payable When dividends are paid: Dividends Payable XXX Cash To close dividends at year end: Retained Earnings XXX Dividends XXX XXX XXX 17

18 Preparing a Post-Closing List of all real accounts. Trial Balance A check of whether total debits equal total credits for all real accounts prior to beginning new accounting cycle. Rodman Industries Inc. Post-Closing Trial Balance December 31, 2009 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 Debits = Credits 18

19 Review of the Accounting Cycle 1 Step 2 Step Step 3 Analyze transactions. Record the effects of the transactions. Summarize the effects of transactions. 1. Posting journal entries. 2. Preparing a trial balance. Step 4 Prepare reports. 1. Adjusting entries. 2. Preparing financial statements. 3. Closing the books. 19