CHAPTER TWO

ACCOUNTING CYCLE. CHAPTER TWO.

Introduction. The accounting cycle refers to the steps in preparing financial statements and they are repeated each reporting period Start with identifying and analyzing business transaction and end with post closing trial balance..

Cont’d. [image] entries (optional) Post -c tr ial balance (optional) Closing preparation I tern e n t Retained earnings Balance sheet Cas h or Transactions and Other Events THE ACCOUNTING CYCLE Wor k (option a I) Adjusted trial balance journa i ization General Cash receipts journal Casn aisbursernents journal Purchases jour Sales journal Other special journals General ledger (usually roonthly) Subsidiary ledgers (usually dai ly) Trial preparation Adj Estirnated i terns.

The Accounting Equation. Accounting equation shows the resources of a business and the claims to those resources. The resources referred as assets, and The claim to the resources are referred as equities. Assets = Equities Equities may be subdivided in to two: the rights of creditors(Liabilities), and the right of owners (shareholders Equity). Thus, accounting equation mathematically expressed as: Assets = Liabilities + Shareholders Equity Financial accounting is based on one simple, three-element equation, referred to as the basic accounting equation.

Cont’d. Assets: are resources owned by a business. They represent probable future economic benefits and arise as the result of past transactions or events. Eg. Cash, receivables, building, land, etc. Liabilities: are claims against assets. They are probable future sacrifices of economic benefits (usually cash) that arise as the result of past transactions or events. Eg. Account payable, note payable, tax payable, etc. Traditionally Liabilities are classified into: Current and Long-term Liabilities.

Cont…. Current Liabilities – are those expected to be satisfied with current assets or by the creation of other current liabilities. Are obligations payable within one year or within operating cycle, whichever is longer. Reported by their maturity value Accounts Payable Short-Term Notes Payable Sales Tax Payable Current Portion of Long-Term Notes Payable Long-term Debt – probable future sacrifices of economic benefits arising from present obligations that are not payable within a year Reported at their presented value Eg. Bonds payable, long-term notes payable, mortgages payable, pension liabilities, lease liabilities etc. It has various covenants or restrictions that protect both lenders and borrowers..

Cont …. Owner’s Equity – is the ownership claim on assets Also referred to as the residual interest – is what remains after creditors’ claims have been honored. Shareholders’ equity changes by: Sale of stock to investors Recognition of periodic net income or loss Declaration of cash dividends to shareholders.

2.2. Source Documents. Source documents are the items that initiation of a financial transaction. They explain the type of transaction and gives all the information needed to claim it. They must be kept on file. eg. Cash Sales slip Sales invoice Purchase invoice Cheque copies.

2.3. Transaction Analysis. Transactions are the exchange of goods or services between entities, as well as other events that have an economic impact on a business. Transaction analysis – is the process used to accounts The specific accounts that were affected, and Changes in status, such as increases or decreases.

2.4. Recording Transactions in Journal.. Transactions and events are initially entered in a record called a journal. Journal – is a chronological (arranged in order of time) record of business transactions. is called book of original entry, b/c transactions are initially recorded in a journal Journalizing – is the process of recording of a business transaction in the journal..

Cont’d. Journal includes the ff. parts, entered step by step. The date of the transaction The title of the account debited and its amount The title of the account credited and its amount Brief explanation of the entry or reference to the source document..

Dec. 1 2005. Prepaid Insurance 2 400 00. Cash 2 400 00.

Illustration. Assume the following transaction and record them in general journal, post to ledger, prepare unadjusted Trial balance Transaction 1: Smart Touch received $30,000 cash on April 1 from Sheena Bright and issued common Stock to her. Transaction 2: On April 2, Smart Touch paid $20,000 cash for purchase of land. Transaction 3: Smart Touch purchased $500 of office supplies on account on April 3, Transaction 4: On April 8, Smart Touch collected cash of $5,500 for service revenue that the business earned by providing e-learning services for clients. Transaction 5: On April 10, Smart Touch performed services for clients, for which the clients will pay the company later. The business earned $3,000 of service revenue on account..

Transaction 6: Smart Touch paid the following cash expenses on April 15: Rent expense on a computer, $600; Office rent, $1,000; Salary expense, $1,200; Utilities expense, $400 Transaction 7: On April 21, Smart Touch paid $300 on the account payable created in transaction 3. Transaction 8: Sheena Bright remodeled her home with personal funds of $3,000 Transaction 9: On April 22, Smart Touch collected $2,000 cash from the client in transaction 5. Transaction 10: On April 24, Smart Touch sold a parcel of land owned by the business. The sale price, $9,000, equaled the cost. Transaction 11: On April 30, Smart Touch received a telephone bill for $100 and will pay this expense next month. Transaction 12: Also on April 30, the business paid cash dividends of $2,000 to Sheena Bright, the Stockholder..

Required : Record the above transactions in General Journal.

Cont…. April 22 Cash …………………….. Account receivable ………… 2000 2000 April 24 Cash ………………… Land ………………………….. 9000 9000 April 30 Utility expense ………………… Account payable …………………. 100 100 April 30 Dividend ……………. Cash ………………………….. 2000 2000.

2.5. Post To Account In The Ledger. Posting – is the process of transferring all the debits and credit items from the journal onto the accounts maintained in the ledger. The steps in posting are given below: Record the date and amount of Dr. and Cr. Entry to the account Insert the Journal page number in the P.R (Post Reference) column of the account. Insert the account number in the P.R column of the journal..

Dec. 31 2005. Prepaid Insurance 2 400 00. Cash 2 400 00.

1. Post. Ref. JOURNAL Date Description Debit Credit Page 1 1 2 3 4 Dec. 1 2005 Prepaid Insurance 2 400 00 Cash 2 400 00 Paid premium on two-year policy. 15.

Posting to the ledger using T-account. [image] Cash Apr 1 30,000 Apr 8 5,500 Apr 22 2,000 Apr 24 9,000 Bal 21 ,ooo Apr 2 20,000 Apr IS 3,200 Apr 21 300 Apr 30 2,000.

Cont…. [image] EXPENSES Rent ex se, com uter Apr 15 Bal 600 600.

2.6. Trial Balance. Trial Balance – is a statement which contains balances of all ledger accounts on a particular date. It consists of a debit column with all debit balances of accounts and credit column with all credit balances of accounts. It proves only the arithmetical accuracy of posting in the ledger. Objectives of Preparing a Trial Balance To check arithmetical accuracy - means writing correct amount, in the correct account and on its correct side while posting transactions from journal to ledger. Helps in making adjustments - Trial balance helps in identifying the items requiring adjustments in preparing the financial statements..

Cont…. Helps in preparing Financial Statements - As Trial Balance contains balances of all ledger accounts, in financial statements the balances of ledger accounts are carried from the Trial balance for proper analysis. Helps in locating errors - If total of two columns of the trial balance is not agrees, it indicates that there is some mistake in the ledger accounts. Helps in comparison - Comparison of ledger account balances of one year with the corresponding balances with the previous year helps the management taking some important decisions..

Cont’d. Smart Touch Learning Inc. Trial Balance April 30, 2018 Account Title Balance Debit Credit Cash $21,000 Accounts receivable 1,000 Office supplies 500 Land 11,000 Accounts payable $300 Common stock 30,000 Dividends 2,000 Service revenues 8,500 Rent expense – computer 600 Rent expense – office 1,000 Salaries expense 1,200 Utilities expense 500 Total $38,800 $38,800.

Finding Trial Balance Errors. If the debit and credit balances in a trial balance are not equal, look for one or more of the following errors: A debit was entered in an account as a credit, or vice versa. The balance of an account was computed incorrectly. An error was made in carrying the account balance to the trial balance. The trial balance was summed incorrectly. Transposing two digits when transferring an amount to the trial balance (for example, entering $23,459 as $23,549).

Example: see the following information. [image] WANDA LANDOWSKA COMPANY TRIAL BALANCE APRIL 30, 2005 Cash Accounts Receivable Prepaid Insurance Equipment Accounts Payable Property Tax Payable Wanda Landowska, Capital Service Revenue Salaries Expense Advertising Expense Property Tax Expense s 4.800 2,570 700 6,960 4200 1,100 $20,890 Credit $ 8,000 4,500 11,200 $24,500.

Cont…. The trial balance of Wanda Landowska Company shown above does not balance. Your review of the ledger reveals the following: Each account had a normal balance. The debit footings in Prepaid Insurance was understated by $100, while account payable was overstated by $100. A transposition error was made: the correct balances for Accounts Receivable and Service Revenue are $2,750 and $6,690, respectively. A debit posting to Advertising Expense of $400 was omitted. A $1,500 cash drawing by the owner was debited to Wanda Landowska, Capital, and credited to Cash. Required: Prepare a corrected trial balance..

Wanda Landowska Company Trial Balance April 30,2005 Account Title Debit Credit Cash $4,800 Account receivable 2,750 Prepaid insurance 800 Equipment 8,000 Accounts payable $4,400 Property tax payable 560 Wanda Landowska, capital 12,700 Withdrawal 1,500 Service revenue 6,690 Salaries expense 4,200 Advertising expense 1,500 Property tax expense 800 24,350 24,350.

2.7. Record & Post Adjusting Entries: Deferrals and Accruals.

Types of Adjusting Entries. Deferrals Prepaid Expenses – are expenses paid in cash and recorded as assets before they are used or consumed. Unearned Revenues – are cash received and recorded as liabilities before revenue is earned. Accruals Accrued Revenues – are revenues earned but not yet received in cash or recorded. Accrued Expenses – are expenses incurred but not yet paid in cash or recorded. NB: Adjusting entries involve either a revenue or an expense account. It involves an income statement account (revenue or expense) along with a balance sheet account (asset or liability).

Adjustment Example. [image] PIONEER ADVERTISING AGENCY INC. TRIAL BALANCE OCTOBER 31, 2005 Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Service Common Stock Dividends Service Revenue Salaries Expense Rent Expense Revenue Debit $ 80.000 72.000 25.000 6,000 50,000 5,000 40.000 9 ooo $287,000 Credit s 50.000 25.000 12.000 100,000 100,000 $287 .ooo.

Cont…. Adjusting entries – Deferrals Pioneer Advertising Agency purchased advertising supplies costing $25,000 on October 5. This account shows a balance of $25,000 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $10,000 of supplies is still on hand. Adjusting entry on October 31 Advertising supplies expense…….15, 000 Advertising supplies ……………………15,000 Note: If the adjusting entry is not made, Expenses will be understated and net income overstated by $15,000. Assets and owners’ equity will be overstated by $15,000.

Cont…. On October 4, Pioneer Advertising Agency Inc. paid $6,000 for a one-year fire insurance policy. The effective date of coverage was October 1. Adjusting entry on October 31 Insurance expense ……….500 Prepaid insurance …………………….500 Depreciation on the office equipment is estimated to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years) Adjustment on October 31 Depreciation expense ………..……400 Accumulated Depreciation …………….400 Note Book value = Cost – Accumulated Depreciation = $50,000 - $400 =$49,600, book value of office equipment.

Cont…. Pioneer Advertising Agency received $12,000 on October 2 from Knox for advertising services expected to be completed by December 31. Adjustment as of October 31: Unearned service revenue …………4,000 Service revenue ……………………….4,000 Accruals: In October Pioneer Advertising Agency earned $2,000 for advertising services that were not billed to clients before October 31 Adjustment on October 31 Account receivable …………….2,000 Service Revenue …………………….2,000.

Cont…. Pioneer signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Thus, Int. exp. = 50,000*12%*1/12=500 Adjustment on October 31 Interest expense ……………500 Interest payable …………………….500 Pioneer last paid salaries on October 26 and it will not pay salaries again until November 23. However, as per the calendar, three working days remain in October (October 29, 30, and 31) and accrued salary of $6000 was not paid. Adjustment on October 31 Salary expense ………….6, 000 Salary payable …………….6, 000.

Cont’d. Assume that, based on past experience; Pioneer reasonably estimates a bad debt expense for the month of October is $1,600. The company uses allowance method of accounting for uncollectible . Adjustment on October 31 Bad debt expense………………..……1,600 Allowance for doubtful account…………...1,600.

2.8. Adjusted Trial Balance. Adjusted TB shows the balance of all accounts, including those adjusted, at the end of the accounting period. The adjusted trial balance thus, shows the effects of all financial events that occurred during the accounting period..

Cont…. [image] Cash Accounts Receivable Allow•ance for Doubtful Accounts Advertising Supplies Prepaid Insurance Office Equiprnent Accurnulated Depreciation— Office Equiprnent Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable Cornrnon Stock Dividends Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Bad Debt Expense PIONEER ADVERTISING AGENCY INC. ADJUSTED TRIAL BALANCE OCTOBER 31, 2010 100.000 106.000 Debit $ 80,000 74,000 10 ,ooo 5.500 50.000 5.000 46.000 1 5 .ooo 9.000 1. ooo $297.500 Credit 1 .600 400 50.000 25.000 8.000 6.000 $297.500.

2.9. Preparation of Financial Statements. Periodically, accountants create financial statements to present an accurate depiction of the financial health of a business. Financial statements are a structured representation of financial position (balance sheet), financial performance (income statement), and the inflow and outflow of cash (cash flow statement) of an entity. Objective of financial statement is to provide entity’s information about The financial position, Financial performance, and Cash flows Financial statements also help to assess the probability that an entity will able to make future cash..

2.9. Preparation of Financial Statements …. The financial statements should be prepared in this order: Income statement – to determine net income Statement of retained earnings – to compute ending retained earnings Balance sheet – which needs the ending capital amount to achieve its balancing feature.

2.9. Preparation of Financial Statements. Income statement, and Statement of Retained Earning.

Balance Sheet. [image] PIONEER ADVERTISING AGENCY INC. Adjusted Trial Balance October 31. 2010 $80,000 PIONEER ADVERTISING AGENCY INC. Balance Sheet October 31. 2010 Assets Account Accounts Receivable Allowance for Doubtful Accounts Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation— Office Equipotent Notes payable Accounts Payable Service Revenue Salaries payable Interest payable on S tock Retained Earnings Dividends Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Bad Debt Expense Debit 74,000 10,000 5,500 50,000 5,000 46.000 Credit $ 400 50,000 25.000 8,000 6,000 500 100,000 —o— 106.000 Cash Accounts receivable Less: Allowance Advertising supplies Prepaid insurance Office equipment Less: Accumulated depreciation Total assets $74,000 1.600 $50,000 $80,000 72,400 10,000 5,500 $217 500 Liabilities and Stockholders' Equity 15,000 9,000 1,600 $207 500 Liabilities Notes payable Accounts payable Unearned service revenue Salaries payable Interest payable Total liabilities Stockholders' equity stock Retained earnings Total liabilities and stockholders' equity Retained Earnings Statetnent in Illustration 3-34 50,000 25,000 8,000 6,000 89, 500 100.000 28.000 $217.500.

Statement of Cash Flows. Cash flow Statements gives additional information to assist decision makers in assessing an entity’s ability: To generate cash Meet financial commitments as they fall due Obtain external finance Etc. Three sections reflecting the major cash flow activities Operating activities Investing activities Financing activities.

Cont’d. Operating Activities Activities relating to provision of goods and services and other activities that are neither investing nor financing activities Activities reported in the income statement are adjusted from accrual to cash basis Cash from operating activities shows ability to: Generate cash Meet short term obligations Continue as a going concern Expand.

Cont’d. Investing Activities – refer activities that relate to the acquisition and disposal of: Non-current assets (plant and other productive assets) Investments (such as securities) not falling within the definition of cash Shows future directions of the entity by reporting major asset acquisition and disposals. Financial Activities – refer activities that change the size and/or composition of the financial structure of the entity Borrowings not falling within definition of cash Associated with changes in long term liabilities and equity.

2.10. Close Temporary Accounts. Closing entry – is the formal process by which all nominal accounts are reduced to zero and the net income or net loss is transferred to an owners’ equity account. Steps in closing: Step-1: Closing Revenue Accounts - Debit each revenue accounts and credit the ‘Income Summary’ account by the total revenue Step-2: Closing Expense Accounts – Debit the income summary account by the total of expenses and credit each expense accounts. Step-3: Closing The Income Summary Account – Income summary will be closed to the capital account. Step-4: Closing Withdrawal/ dividend – Debit the owners equity account by the total of drawings for the period and credit the drawing account..

Example from Poineer Adv. Agency. [image] Oct. 31 31 31 31 Closing Entries (1) Service Revenue Incorne Surnrnary (To close revenue account) (2) Income Surnmary Advertising Supplies Expense Depreciation Expense Insurance Expense Salaries Expense Rent Expense Interest Expense Bad Debt Expense (To close expense accounts) (3) Incorne Surnmary Retained Earnings (To close net income to retained earnings) Retained Earnings Dividends (To close dividends to retained earnings) 106,000 106,ooo 73,000 15,000 500 46.000 9,000 1 ,600 33,000 33,000 5,000 5,000.

2.11. Post Closing Trial Balance. [image] Account Cash Accounts Receivable Allowance for Doubtful Accounts Advertising Supplies Prepaid Insurance Office Equiprnent Accurnulated Depreciation—Office Notes Payable Accounts Payable Unearned Service Revenue Salaries Payable Interest Payable Common Stock Retained Earnings PIONEER ADVERTISING AGENCY INC. POST-CLOSING TRIAL BALANCE OCTOBER 31, 2010 1 oo,ooo Equipment Debit 80,000 74,000 10,000 5,500 50,000 $219,500 Credit 1 ,600 400 50,000 25,000 8,000 6,000 500 28,000 $219,500.

Assignment1: Assume that the following transaction is related to pioneer advertising company during the month of October, 2001: October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc. October 1: Pioneer Advertising purchases office equipment costing $50,000 by signing a 3-month, 12%, note payable. October 2: Pioneer Advertising receives a $12,000 cash advance from R. Knox, a client, for advertising services that are expected to be completed by December 31. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that will expire next year on September 30. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply..

October 20: Pioneer Advertising’s board of directors declares and pays a $5,000 cash dividend to stockholders. October 26: Pioneer Advertising pays employee salaries and wages in cash. Employees are paid once a month, every four weeks. The total payroll is $10,000 per week, or $2,000 per day. In October, the pay period began on Monday, October 1. As a result, the pay period ended on Friday, October 26, with salaries and wages of $40,000 being paid. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 provided in October..