STEPS IN THE ACCOUNTING CYCLE

Transcription

1 ACCT 321, Intermediate Accounting I, Ch. 3 Notes The accounting cycle is not what the teacher rides to school each day STEPS IN THE ACCOUNTING CYCLE 1. The accounting cycle begins with a transaction or event that impacts the financial statements and can be measured. Such transactions are usually cash or near-cash transactions. Hiring a new CEO is not an accounting transaction (until the CEO is paid) but purchasing a box of paper clips is an accounting transaction. 2. The transaction is recorded in a journal (book of original entry). Special journals can facilitate the recording of similar transactions. For more on Special Journals, see below. BOOK OF ORIGINAL ENTRY

2 Special Journals Most transactions are not entered in the general journal but rather in special journals. The purpose of special journals is to use a format that is more efficient than the cumbersome general journal, and to bunch like transactions into one place so that posting can be done for many transactions in one total. Types of Journals Sales Journal - all sales of inventory on credit Purchases Journal - all purchases of inventory on credit Cash Receipts Journal - all incoming cash (even cash sales) Cash Disbursements or Payments Journal or just Check Register - all outgoing cash that is paid with checks. General Journal - any entry that doesn't fit in one of the four special journals above (e.g. return of inventory, adjusting entries, closing entries) In QuickBooks, most of the entry windows are special journals. Although the rules for traditional journals don t exactly apply in QuickBooks, many of the same concepts apply. For example, the Invoice window is a special sales journal. The Write Check window is a special cash disbursements journal. 3. The entries in journals are posted to the general ledger (a book of T-accounts). Posting is done automatically in computerized systems. In on-line-real-time systems, the entries are posted immediately. In batch-processing systems, the entries may be posted weekly or monthly. Subsidiary ledgers are used to record numerous detailed transactions that might occur in accounts like A/R, equipment, A/P, and payroll. A/R subsidiary ledgers need be updated frequently to determine customer balances at any point in time. Subsidiary Ledgers (A/R, A/P, Equipment, Payroll, etc.) e.g. A/R Ledger. Accts are created for each customer with detailed, daily transactions in detail. ABC Cust. XYZ Cust. T T

3 4. A trial balance (unadjusted) is usually prepared to make sure that debits still equal credits. A trial balance can be prepared at any time. Trial balances can be prepared automatically in computerized systems. 5. Adjusting entries are prepared to correct the accounts and bring them up-to-date. For more on Adjusting Entries, see below. 6. Another trial balance (adjusted trial balance) is often prepared to make sure that debits still equal credits. This is done automatically in computerized systems. a. NOTE: Sometimes accountants will use a worksheet to process adjusting entries and prepare trial balances, but this is optional. 7. From the adjusted trial balance, financial statements can be prepared. This is done automatically in computerized systems. On manual systems, an income statement should be prepared first, so that net income can be used to prepare a statement of owner s equity. Next, comes the statement of changes in owners equity, the ending balance of which goes to the balance sheet. Next, the balance sheet should be prepared. Finally, the statement of cash flows can be prepared. 8. Closing entries are made to zero out the temporary income/expense/withdrawals accounts so that they can start from zero in the new period. This is done automatically in computerized systems. For more on Closing Entries, see below. 9. Some accountants will prepare another trial balance here (post-closing trial balance) to make sure that debits still equal credits. This is an optional step. In computerized systems, a trial balance can be prepared automatically. 10. An optional but helpful step is for accountants to prepare reversing entries in the new period. These facilitate the year-end cutoff process for revenues and expenses. For more on Reversing Entries, see below. The accounting cycle is now complete and a person would start over with step one for the new fiscal period. THE BALANCE SHEET EQUATION AND DEBITS/CREDITS Assets = Liabilities PLUS Owner Equity Debits = Credits The left side of the balance sheet equation (assets) increases with debits (normal balance is a debit balance). Exceptions include asset contra accounts (e.g. allowance for doubtful accounts, accumulated depreciation) that increase with credits. The right side of the balance sheet (liabilities and equity) increases with credits. Exceptions include accounts that reduce equity (expenses & withdrawals) and a few contra liability and equity accounts (discount on bonds payable, treasury stock, etc.). Four different kinds of changes in equity include: (1) income or revenue, (2) expenses, (3) owner contributions, and (4) owner withdrawals (or dividends if a corporation). The first two changes

4 constitute net income. Changes #1 and #3 increase equity and therefore have credit balances. Changes #2 and #4 decrease equity and therefore have debit balances. TYPES OF ADJUSTING ENTRIES Adjusting entries must be made before the books are closed in order to correct the accounts for unrecorded expenses and revenues. There are five types of adjusting entries. Those entries that can be reversed are shown with an R in the right margin. 1. Prepaid Expenses (Prepaid Insurance, Prepaid Rent, Supplies, etc.) Original Adjusting A. Prepaid Asset Expense Cash Prepaid Asset OR

5 B. Expense Prepaid Asset R Cash Expense 2. Prepaid Revenues (Unearned or Deferred Revenue) Original Adjusting A. Cash Unearn. Rev - Liab. Unearn. Rev. - Liab. Revenue (earned) OR B. Cash Revenue (earned) R Revenue (earned) Unearn. Rev. - Liab. 3. Accrued Expenses (Wages, Utilities, Interest, etc.) Original Adjusting N/A Expense R Payable 4. Accrued Revenues (Interest, etc.) Original Adjusting N/A Receivable R Revenue 5. Estimated Items (Bad Debt Expense, Depreciation Expense, etc.) Bad Debt Expense Allowance for Doubtful Accounts (contra A/R) Depreciation Expense Accumulated Depreciation (contra building or equipment) REVERSING ENTRIES Reversing entries are an optional but helpful tool used by accountants to facilitate the yearend cutoff process for revenues and expenses. The adjusting entries that can be reversed are indicated above with an R in the right margin. Rules for when to reverse adjusting entries are summarized below. Only reverse the following types of adjusting entries: Prepaid Expense in which original entry debited expense. Prepaid Revenue in which original entry credited revenue. Both Accrued Expenses and Accrued Revenues. Do NOT reverse the following types of adjusting entries: Prepaid Expense in which original entry debited prepaid asset. Prepaid Revenue in which original entry credited unearned revenue-liability. All Estimated Items

6 EXAMPLE OF REVERSING PROCEDURE: Suppose that salaries of $5,000 were paid every Friday during the year. For the last week of the year, December 31 falls on a Wednesday, which means that three days belong in the old year and two days in the new year. Notice that under reversing entries, the entry to record the payment of $5,000 each week can continue on in an automated fashion. ENTRIES - NO REVERSING PROCEDURE Every Friday during year Salaries Expense 5,000 Cash 5,000 Dec. 31 Adjusting Entry Salaries Payable 3,000 Dec. 31 Closing Entries OE-Capital 3,000 Jan. 2 (Friday) Payroll Payment Salaries Expense 2,000 Salaries Payable 3,000 Cash 5,000 ENTRIES USING REVERSING PROCEDURE Every Friday during year Salaries Expense 5,000 Cash 5,000 Dec. 31 Adjusting Entry Salaries Payable 3,000 Dec. 31 Closing Entries OE-Capital 3,000 Jan. 1 Reversing Entry Salaries Payable 3,000 Jan. 2 (Friday) Payroll Payment Salaries Expense 5,000 Cash 5,000 CLOSING ENTRIES Purpose is to remove the balances from all temporary or nominal accounts (revenues, expenses, withdrawals) and place them into owner's equity (capital). Although textbooks often show the use of an Income Summary account, in practice temporary accounts usually are closed directly into capital. Using an Income Summary account is entirely optional and is basically an invention of academics. Usual Steps: Close all temporary accounts with credit balances (e.g. revenues) by debiting them and place the total into capital as a credit. Close all temporary accounts with debit balances (e.g. expenses, withdrawals) and place total into capital as a debit. OR Close all temporary accounts in one gigantic entry with the net amount placed into capital.

7 A NOTE ON THE ACCRUAL BASIS ACCOUNTING Under the accrual basis, revenue is recorded when earned and expense when incurred, regardless of when cash is received or paid. The accrual basis of accounting is required by GAAP because it matches revenues against expenses to produce a meaningful net income and because it makes manipulation of net income difficult. Companies that must follow GAAP (e.g. publicly traded) use the accrual basis, but many private or small companies use the cash basis. For more information about the differences between the cash and accrual basis, refer to Appendix 3A in your textbook, or see A NOTE ON ORIGIN OF DOUBLE ENTRY ACCOUNTING The innovative Italians of the Renaissance (14th -16th century) are widely acknowledged to be the fathers of modern accounting. They elevated trade and commerce to new levels, and actively sought better methods of determining their profits. Although Arabic numerals were introduced long before, it was during this period that the Italians became the first to use them regularly in tracking business accounts an improvement over Roman numerals the importance of which cannot be overstated. They kept extensive business records, as the use of capital and credit on a large scale developed: The evolutionary trend toward double entry bookkeeping was underway. Luca Pacioli was a true Renaissance man, with knowledge of literature, art, mathematics, business and the sciences, at a time when few could even read. Born about 1445 at Borgo San Sepulcro in Tuscany, Frater Luca Bartolomes Pacioli acquired an amazing knowledge of diverse technical subjects religion, business, military science, mathematics, medicine, art, music, law and language. He accepted the popular belief in the inter-relatedness of these widely varying disciplines and in the special importance of those, such as mathematics and accounting, which exhibit harmony and balance. His friend Leonardo da Vinci helped prepare the drawings for Pacioli's 1497 work, Divina Proportione; In turn, Pacioli is reputed to have calculated for da Vinci the quantity of bronze needed for the artist's huge statue of Duke Lidovico Sforza of Milan. Around 1482, after completing his third treatise on mathematics, Pacioli, who like many of his time sought preferment as a teacher, became a Franciscan friar. He traveled throughout Italy

8 lecturing on mathematics, and, in 1486, completed his university education with the equivalent of a doctorate degree. Pacioli never claimed to have invented double entry bookkeeping. Thirty-six years before his monumental treatise on the subject, Benedetto Cotrugli wrote Delia Mercatura et del Mercante Perfetto (Of Trading and the Perfect Trader), which included a brief chapter describing many of the features of double entry. Although this work had not been published for more than a century, Pacioli was familiar with the manuscript and credited Cotrugli with originating the double entry method. Pacioli was about 50 years old in 1494 just two years after Columbus discovered America when he returned to Venice for the publication of his fifth book, Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportion). It was written as a digest and guide to existing mathematical knowledge, and bookkeeping was only one of five topics covered. The Summa's 36 short chapters on bookkeeping, entitled "De Computis et Scripturis" ("Of Reckonings and Writings"), were added, "in order that the subjects of the most gracious Duke of Urbino may have complete instructions in the conduct of business," and to, "give the trader without delay information as to his assets and liabilities." (All quotes from the translation by J.B. Geijsbeek, "Ancient Double Entry Bookkeeping: Lucas Pacioli's Treatise," 1914). Perhaps the best proof that Pacioli's work was considered potentially significant, even at the time of publication, was the very fact that it was printed on November 10, Gutenberg had, just a quarter century earlier, invented metal type, and it was still an extremely expensive proposition to print a book. "De Computis" begins with some basic instruction for commerce. The successful merchant, declares Pacioli, needs three things: sufficient cash or credit, good bookkeepers and an accounting system which allows him to view his finances at a glance. Before commencing business, one should prepare an inventory listing all business and personal assets and debts. This inventory must be completed within one day, and property should be appraised at current market values and arranged according to mobility and value, with cash and other valuables listed first since they are most easily lost. The memorandum, or memorial, was Pacioli s equivalent of a daybook, for the recording, in chronological order, of business transactions as they occurred. The transaction could be entered in any of the various monetary units then in use in the Italian city-states of the time, with conversion to a common currency for double entry left for later. The journal was the merchant's private account book. Entries consisted of a narrative debit, credit and explanation in one continuous paragraph. The journal had only one column, which was not totaled. There were no compound entries. Pacioli's ledger was, of his three books, the most like its modern equivalent. The money and date columns were almost identical to those in modern ledgers, with entries consisting of brief paragraphs, debits on the left side of a double page (deve dare) and credits on the right (deve avere). The bookkeeper posts "cash in hand" as a debit on page one of the ledger, just as it was entered first in the journal. As ledger postings are made, two diagonal lines are drawn through each journal entry, one from left to right when the debit is posted and the other from right to left when the credit is posted.

9 The first 16 chapters of "De Computis" describe this basic system of books and accounts, while the remaining 20 are devoted to specialized accounting issues of merchants. These include bank deposits and withdrawals, brokered purchases, drafts, barter transactions, joint venture trading, expense disbursements and closing and balancing books. The trial balance (summa summarium) is the end of Pacioli's accounting cycle. Debit amounts from the old ledger are listed on the left side of the balance sheet and credits on the right. If the two totals are equal, the old ledger is considered balanced. If not, says Pacioli, "that would indicate a mistake in your Ledger, which mistake you will have to look for diligently with the industry and intelligence God gave you." In the first century after its publication, the Summa was translated into five languages, and numerous books on double entry bookkeeping appeared in Dutch, German, English and Italian whose descriptions were obviously lifted from "De Computis." Many consider these works inferior explanations of the system so clearly articulated by Pacioli. One historian has described the works issued during this period as, "at the best, revisions of Pacioli, at the worst servile transcriptions without even the courtesy of referring to the original author." Nevertheless, they helped quickly spread the knowledge of the "Italian method" throughout Europe. Perhaps most surprising is how little bookkeeping methods have changed since Pacioli. Both the sequence of events in the accounting cycle and the special procedures he described in "De Computis" are familiar to modern accountants. In fact, the primary differences between current bookkeeping practices and the "Method of Venice" are additions and refinements brought about by the needs of a larger scale of business operation. The small proprietorships of 15th century Italy had no need for specialized journals, subsidiary ledgers, controlling accounts, formal audit systems, cost accounting or budgeting. Some omissions, such as the failure to touch on accruals and deferrals, probably occurred because Pacioli felt they were too advanced for a beginner s treatise. But numerous tiny details of bookkeeping techniques set forth by Pacioli were followed in texts and the profession for at least the next four centuries, as accounting historian Henry Rand Hatfield put it, "persisting like buttons on our coat sleeves, long after their significance had disappeared."