Review of the Accounting Process THE BASIC MODEL

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1 THE BASIC MODEL The accounting information system is designed to collect and organize data into information that is useful for stakeholders. The Accounting Equation The basic accounting equation is what drives double-entry bookkeeping. The equation reflects the accounts reported in the balance sheet. The basic accounting equation is as follows: ASSETS = LIABILITIES + OWNERS' EQUITY This is a very simple algebraic equation that reflects that the assets of an entity must be supported by either debt or equity. As in algebra if we add or subtract something from one side of the equation we must add or subtract the same amount on the other side of the equation. For example, if we were to increase cash (an asset) we might have to increase note payable (a liability account) so that the basic accounting equation remains in balance. ASSETS = LIABILITIES + OWNERS' EQUITY $500 = $500 In accounting language an increase in an asset account is called a debit and an increase in a liability or equity account is called credit. Likewise, if we decrease in asset account we credit the account and on the other side of the equation we debit a liability or equity account which reduces its balance. The normal balance in an asset account is a debit. In contrast, to keep the accounting equation in balance the normal balance in a liability or equity account is a credit. The accounting equation provides the foundation for what eventually becomes the balance sheet. T-Account Analysis In double-entry bookkeeping, the terms debit and credit are used to identify which side of the ledger account an entry is to be made. Debits are on the left side of the ledger and Credits are on the right side of the ledger. It does not matter what type of account is involved. For example if we received $500 in cash as a loan from the bank, the entry would be as follows: CASH NOTE PAYABLE Debit Credit Debit Credit $500 $500 The debit to cash increases the Cash Account by $500 while the credit to Note Payable increases this liability account by the same $500. Above, we analyzed the accounting equation in terms of assets, liabilities and owners equity. These are called real or permanent accounts. By this we mean that these accounts remain open and active for the life of the enterprise. In contrast there are accounts that reflect activities for a specific accounting period. These are called nominal or temporary accounts. 1

2 Using the accounting equation format we can now expand our analysis to include both real and nominal accounts. The nominal accounts reflect an accumulation of transactions for a specific accounting period. Each account is closed to the Retained Earnings account at the end of the accounting period, which is an owners equity (stockholders equity) account. Expense Accounts Resources that are not used up currently are assets that provide resources for future accounting periods. Resources that are used in the current accounting period are called expenses. At the end of each accounting period expenses are closed out to the Retained Earnings Account which decreases Owners Equity. Therefore, expense accounts carry a normal debit balance. Revenue Accounts Revenue accounts reflect the accumulation during the current accounting period of potential additions to retained earnings. At the end of the accounting period accumulation of revenues during the period are closed to the Retained Earnings Account which increases Owners Equity. Therefore revenue accounts carry a normal credit balance (the same balance as the Retained Earnings Account). Dividends Declared Account Dividends declared reflect a distribution of assets to shareholders. In a sense, Cash Dividends are similar to an expense account except that the distribution is to the owners rather than for expenses that are required to generate revenue. Therefore the Dividends Declared Account carries a normal debit balance. The following provides a graphic overview with the application of the accounting equation. Note that the accounting equation has been expanded to include the nominal accounts. The asset and expense accounts (the left hand side of the equation) should always equal the liability, equity and revenue accounts (the right hand side of the equation.) REAL ACCOUNTS Asset Accounts = Liability Accounts + Equity Accounts Normal Balance Normal Balance Normal Balance Debit Credit Debit Credit Debit Credit NOMINAL ACCOUNTS Expense Accounts Revenue Accounts Normal Balance Normal Balance Debit Credit Debit Credit Example: The following are transactions that entered into during the month of June. On June 4 Spencer invests $3,000 cash in exchange for common stock. On June 6 the Company purchases equipment on account for $1,100. On June 7 the Company pays $400 to landlord for June rent. On June 18 the Company bills Sophie Company $500 for consulting services. Each transaction is journalized (using general journal format) as follows: 2

3 Date Account Debit Credit 6/4/06 Cash $3,000 Common stock $3,000 To record the sale of common stock 6/6/06 Equipment $1,100 Accounts payable $1,100 To record the purchase of equipment on account 6/7/06 Rent expense $400 Cash $400 To record the payment of rent for the month of June 6/18/06 Accounts receivable $500 Service revenue $500 To record the billing for consulting services during June As mentioned above, the nominal accounts are closed into retained earnings (equity account) at the end of each accounting period. Using the transactions that we journalized for the month of June, the following demonstrates how these would be reflected in the accounting equation. ASSETS = LIABILITIES + OWNERS' EQUITY $3,000 = $3,000 $1,100 = $1,100 ($400) = ($400) $500 = $500 $4,200 = $1,100 + $3,100 Financial Statements and Ownership Structure In this course we will be using the corporate form of ownership. The Equity Accounts in a corporation include Common Stock, and Retained Earnings. Common Stock reflects the amount of capital contributed by the owners of the business entity. Retained Earnings reflects the retention of net income less any dividends paid since the inception of the corporation. THE ACCOUNTING CYCLE The accounting cycle is a continuous process of accumulating, summarizing and reporting financial information. The steps include: Step 1-Transactions and/or Events: Identification and measurement of external transactions and internal events. Step 2-Journalization: Through the use of specialized journals (such as the sales journal, the purchases journal, the cash receipts journal, the cash disbursements journal and the payroll journal) and the general journal the transactions and events are entered into the accounting records. These are called the books of original entry. 3

4 Step 3-Posting: The summarized (in specialized journals) or individual transactions (in the general journal) are then posted from the journals to the general ledger (and subsidiary ledgers). Nothing should ever get to the ledgers without first being entered in a journal. Step 4-Unadjusted Trial Balance: At the end of an accounting period the working trial balance is prepared. This involves copying each account name and account balance to a worksheet (working trial balance). The resulting first two columns of the worksheet are called the unadjusted trial balance. Step 5-Identify Adjusting Journal Entries for Worksheet: Using the unadjusted trial balance, each account is analyzed to determine the accruals and deferrals that need to be recorded. Each adjusting journal entry is recorded in the columns provided on the working trial balance. Step 6-Adjusted (Final) Trial Balance: Each account is adjusted for any adjusting journal entry recorded on the worksheet and the final adjusted balance is entered in the appropriate column entitled Final Trial Balance. These amounts reflect the corrected balances in each account that will eventually be reported in the financial statements. Once the two columns are footed and balance the appropriate amounts are extended to the balance sheet and income statement columns of the worksheet. Again, the columns are footed and the difference in debits and credits for both the income statement and balance sheet sections should be identical and should reflect the net income or loss for the period. Step 7-Preparation of the Financial Statements: Using the information from the worksheet, the financial statements are prepared. The income statement is prepared first so that net income can then be recorded in the statement of retained earnings. The statement of retained earnings is prepared next to determine the ending balance of retained earnings. Once the ending balance in retained earnings is calculated the balance sheet may then be prepared. The statement of cash flows is prepared last and we will learn in a subsequent lesson the worksheet approach to preparing this statement. Step 8-Journalize the Period End Adjusting Entries: Once the financial statements are prepared the proposed adjusting journal entries should be posted to the general journal. Step 9-Post the Period End Adjusting Entries: The journalized adjusting journal entries should then be posted to the general ledger (and subsidiary ledgers). At this point the general ledger and the final trial balance should have the same set of numbers. Step 10-Journalize the Closing Journal Entries: The closing journal entries consist of four sets of journal entries. All of the nominal revenue accounts should be closed to the income summary account. Debit revenue and credit income summary. All of the nominal expense accounts should be closed to the income summary. Credit expense and debit income summary. The balance in the income summary account should now reflect the net income for the accounting period. The next journal entry should close the income summary account to the retained earnings account. If there is a net profit this entry will be a debit to income summary and a credit to retained earnings. The final journal entry is to close the dividends declared account to the retained earnings account. If there were dividends declared during the accounting period this journal entry will be a credit to dividends declared and a debit to retained earnings. 4

5 Step 11-Post the Closing Journal Entries: Once the four closing journal entries have been entered into the general journal, the information should be posted to the general ledger. When this is accomplished all of the nominal accounts in the general ledger should have zero balances. Step 12-Post Closing Trial Balance: To double check on this we prepare another trial balance based on the new balances in the general ledger. The amounts in the post closing trial balance should be the same as the amounts in the balance sheet that was prepared in step 7. If we have any nominal accounts with positive balances a mistake was made along the way and will need to be corrected before proceeding to the next accounting period. ADJUSTING ENTRIES There are four sources of adjusting entries. Adjusting entries can result from: Expensing an asset used during the accounting period, Performing services or delivering goods to earn revenue that the customer paid for up front, Expensing resources that were used during the accounting period but have not been paid for, and Recognizing revenue that has not been received in cash. Exercise: has a fiscal year-end of June 30 th. The following adjusting journal entries must be prepared in order to bring the accounting records up to date for the preparation of year-end financial statements. Interest on notes payable of $400 is accrued. Fees earned but unbilled total $1,400. Salaries earned by employees of $700 have not been recorded. Bad debt expense for year is $900. Each adjustment is journalized (using general journal format) as follows: Date Account Debit Credit 6/30/06 Interest expense $400 Interest payable $400 To accrue interest on note payable through June 30, /30/06 Accounts receivable $1,400 Service revenue $1,400 To record service revenue for services unbilled at year-end 6/30/06 Salaries expense $700 Salaries payable $700 To accrue salaries through June 30, /30/06 Bad debt expense $900 Allowance for doubtful accounts $900 To record bad debt expense for the year-ended June 30, THE CLOSING PROCESS 5

6 Revenue, Expense and Dividends Declared accounts are closed at the end of each accounting period. These accounts are closed to a VERY temporary account called Income Summary. Income Summary exists only as a collection point at the end of the period for the closing process. The following is an example of the closing process. Note that the balance in the Equity Accounts is $25,000. We end the year with $100,000 balance in the asset accounts, $25,000 balance in the liability accounts, $250,000 balance in the expense accounts and $300,000 balance in the revenue accounts. We have omitted the Dividends Declared account in this example. In closing the nominal accounts at year-end, the $300,000 of Revenues (credits) is closed to the Income Summary Account {1} and the $250,000 of Expenses (debits) is closed to the Income Summary Account {2}. The net of these two amounts (net income) is then closed to Retained Earnings {3}. Once the nominal accounts are closed, the year-end accounting equation represents the balance sheet on the last day of the accounting period. Asset Accounts = Liability Accounts + Equity Accounts Debit Credit Debit Credit Debit Credit $100,000 $25,000 $25,000 50,000 $100,000 $25,000 $75,000 3 Expense Accounts Revenue Accounts Debit Credit Debit Credit $250,000 $300,000 $250, $300,000 $0 $0 2 3 Income Summary Debit Credit $250,000 $300,000 $50,000 $0 1 The Working Trial Balance The following comprehensive example takes you through the process of preparing a working trial balance. Comprehensive Example: has a fiscal year end of September 30 th. The general ledger has the following account balances as of September 30, 2002: 6

7 Working Trial Balance September 30, 2002 Unadjusted Trial Balance Account Debit Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts $200 Inventory 27,000 Prepaid insurance 450 Equipment 50,000 Accumulated depreciation 20,000 Accounts payable 10,300 Salaries payable Payroll taxes payable Income taxes payable Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales 120,000 Cost of goods sold 40,000 Office expense 3,550 Administrative salaries 30,000 Payroll taxes 4,500 Bad debt expense Insurance expense 10,950 Rent 5,000 Depreciation Income tax expense $209,500 $209,500 In conducting an analysis of the accounts we find the following: (1) Based on the aged accounts receivable the controller determined that the allowance for doubtful accounts should be 3% of the balance in accounts receivable at September 31, (2) The company has one insurance policy, which is renewed each year on July 1 st. The payment of $6,000 on July 1, 2002 was for a one-year policy that will expire on June 30, (3) The company calculates depreciation expense using the straight-line method. The equipment has an estimated service life of 20 years and no salvage value. (4) Payroll is paid on the first day of each month for the previous months services. As of September 30, 2002 the company has accrued payroll payable of $3,000. (5) The payroll taxes associated with payroll are calculated at 15% of gross payroll. The adjusting journal entries for each one of the above deferrals or accruals is as follows: 7

8 Proposed Adjusting Journal Entries September 30, 2002 Account Debit Credit (1) Bad debt expense $760 Allowance for doubtful accounts $760 To record the allowance for doubtful accounts at 9/30/02 (2) Prepaid insurance $4,050 Insurance expense $4,050 To record prepaid insurance for 9 per month (3) Deprecation expense $2,500 Accumulated depreciation $2,500 To record deprecation for the year ended 9/30/02 (4) Administrative salaries $3,000 Salaries payable $3,000 To record salaries payable on 9/30/02 (5) Payroll taxes $450 Payroll taxes payable $450 To record payroll taxes on salaries payable at 9/30/02 Now that we have analyzed the accounts and prepared the proposed adjusting journal entries we are going to enter each one to the working trial balance. Click on the audio and follow the process of entering each proposed adjusting journal entry. 8

9 Working Trial Balance September 30, 2002 Unadjusted Trial Balance Adjusting Journal Entries Account Debit Credit # Debit # Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts $200 1 $760 Inventory 27,000 Prepaid insurance $4,050 Equipment 50,000 Accumulated depreciation 20, ,500 Accounts payable 10,300 Salaries payable 4 3,000 Payroll taxes payable Income taxes payable 6 Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales 120,000 Cost of goods sold 40,000 Office expense 3,550 Administrative salaries 30, ,000 Payroll taxes 4, Bad debt expense Insurance expense 10, ,050 Rent 5,000 Depreciation 3 2,500 Income tax expense 6 $209,500 $209,500 $10,760 $10,760 Because of space limitations the following displays the adjusting journal entries that we just entered and the final trial balance columns. The process is one of starting with the balance in the unadjusted trial balance column, adding or subtracting the proposed adjusting journal entry and entering the final correct balance in the adjusted trial balance columns. 9

10 Working Trial Balance September 30, 2002 Adjusted Trial Adjusting Journal Entries Balance Account # Debit # Credit Debit Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts 1 $760 $960 Inventory 27,000 Prepaid insurance 2 $4,050 4,500 Equipment 50,000 Accumulated depreciation 3 2,500 22,500 Accounts payable 10,300 Salaries payable 4 3,000 3,000 Payroll taxes payable Income taxes payable 6 0 Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales 120,000 Cost of goods sold 40,000 Office expense 3,550 Administrative salaries 4 3,000 33,000 Payroll taxes ,950 Bad debt expense Insurance expense 2 4,050 6,900 Rent 5,000 Depreciation 3 2,500 2,500 Income tax expense 6 0 $10,760 $10,760 $216,210 $216,210 Please note that we have not entered proposed adjusting journal entry #6. We need to determine the pre-tax income before we can calculate the income tax. To do this we will extend the working trial balance in the manner demonstrated in your book. There are two columns for the income statement and two columns for the balance sheet. 10

11 Working Trial Balance September 30, 2002 Income Statement Balance Sheet Account Debit Credit Debit Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts $960 Inventory 27,000 Prepaid insurance 4,500 Equipment 50,000 Accumulated depreciation 22,500 Accounts payable 10,300 Salaries payable 3,000 Payroll taxes payable 450 Income taxes payable 0 Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales $120,000 Cost of goods sold $40,000 Office expense 3,550 Administrative salaries 33,000 Payroll taxes 4,950 Bad debt expense 760 Insurance expense 6,900 Rent 5,000 Depreciation 2,500 Income tax expense 0 96, , ,550 96,210 23,340 23,340 $120,000 $120,000 $119,550 $119,550 Based on the extensions it appears that we have a pretax income of $23,340. The company has an average income tax rate of 15% of taxable income. Therefore the following proposed adjusting journal entry needs to be prepared. Account Debit Credit (6) Income tax expense $3,501 Income taxes payable $3,501 To record income tax expense on $23,340 of net income 11

12 Now that we know the current period income tax we can return to the working trial balance and enter this last proposed adjusting journal entry. Working Trial Balance September 30, 2002 Adjusted Trial Adjusting Journal Entries Balance Account # Debit # Credit Debit Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts 1 $760 $960 Inventory 27,000 Prepaid insurance 2 $4,050 4,500 Equipment 50,000 Accumulated depreciation 3 2,500 22,500 Accounts payable 10,300 Salaries payable 4 3,000 3,000 Payroll taxes payable Income taxes payable 6 3,501 3,501 Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales 120,000 Cost of goods sold 40,000 Office expense 3,550 Administrative salaries 4 3,000 33,000 Payroll taxes ,950 Bad debt expense Insurance expense 2 4,050 6,900 Rent 5,000 Depreciation 3 2,500 2,500 Income tax expense 6 3,501 3,501 $14,261 $14,261 $219,711 $219,711 Now that we have all of the proposed adjusting journal entries entered on the working trial balance we can extend the final two accounts: income tax expense and income taxes payable. The extended columns for the income statement and balance sheet will look as follows. 12

13 Working Trial Balance September 30, 2002 Income Statement Balance Sheet Account Debit Credit Debit Credit Cash $6,050 Accounts receivable 32,000 Allowance for doubtful accounts $960 Inventory 27,000 Prepaid insurance 4,500 Equipment 50,000 Accumulated depreciation 22,500 Accounts payable 10,300 Salaries payable 3,000 Payroll taxes payable 450 Income taxes payable 3,501 Note payable 30,000 Common stock 20,000 Retained Earnings 9,000 Sales $120,000 Cost of goods sold $40,000 Office expense 3,550 Administrative salaries 33,000 Payroll taxes 4,950 Bad debt expense 760 Insurance expense 6,900 Rent 5,000 Depreciation 2,500 Income tax expense 3, , , ,550 99,711 19,839 19,839 $120,000 $120,000 $119,550 $119,550 Note that after making proposed adjusting journal entry #6 we have net income of $19,839. This is the amount that will be reported in the income statement. The following link provides a copy complete the working trial balance in Excel. workingtrialbalance CONVERSION OF CASH TO ACCRUAL BASIS OF ACCOUNTING Many times accountants are called upon to take a deposit book (cash receipts) and a checkbook (cash disbursement) and convert the cash transactions for the accounting period into accrual accounting financial statements. It is important to remember that the deposits in the deposit book may reflect income earned in a previous accounting period and that checks written in the 13

14 checkbook may reflect bills incurred in a previous accounting period. Therefore the first step in converting from cash to accrual basis accounting is to determine the amounts of receipts and disbursements that belong in the previous accounting period. Once this is accomplished then we need to look at transactions that might have taken place in the current accounting period that have not been converted into cash as of the end of the period. The following is an example of a cash basis business entity that needs to prepare accrual basis financial statements for the bank. The check book and deposit book of reflects the following for the year ended December 31, Cash Basis Income For the Year Ended December 31, 2002 Amount Receipts $253,000 Disbursements 87,900 Cash basis income $165,100 As a result of inspecting the accounting records we discover that the company collected $9,000 in receipts that were earned in 2001 and that the company billed $14,000 for services provided in December 2002 but not received until January The conversion of cash receipts to accrual basis revenue should be calculated as follows: Conversion of Cash to Accrual Basis For the Year Ended December 31, 2002 Account Amount Revenue for services $250,000 Interest earned 3,000 Cash basis income 253,000 Subtract receipts that reflect prior year earnings (9,000) Add earnings not yet converted into cash 14,000 Accrual basis income $258,000 The checkbook also reflects that $6,500 in payments made in 2002 are for expenses related to Looking through the office manager s in-box we discover that there are $8,900 in unpaid bills as of December 31, The conversion of cash disbursements to accrual basis expenses should be calculated as follows: 14

15 Conversion of Cash to Accrual Basis For the Year Ended December 31, 2002 Account Amount Salaries and wages $60,000 Payroll taxes 9,000 Rent 12,000 Utilities 2,400 Transportation 3,000 Office expense 1,500 Cash basis disbursements 87,900 Subtract expenses of prior year obligations (6,500) Add expenses for current year not yet paid 8,900 Accural basis expenses $90,300 Now that we have completed the conversion from cash basis to accrual basis for both receipts and disbursements we can now prepare an accrual basis income statement. The following is the income statement that would be presented to the bank. Accrual Basis Income Statement For the Year Ended December 31, 2002 Amount Revenue $258,000 Expenses 90,300 Net income $167,700 15

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