Accounting cycle

The Accounting Cycle The accounting cycle is the process by which accountants prepare financial statements for an entity for a specific period of time.

The Accounting Cycle 1. Analyze business transactions 2. Journalize the transactions 6. Prepare an adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare a post-closing trial balance 4. Prepare a trial balance 3. Post to ledger accounts 5. Journalize and post adjusting entries

The Accounting Cycle For a new business, begin by setting up ledger accounts. For an established business, begin with account balances carried over from the previous period.

Account: An account is an individual accounting record of increases and decreases labeled as debits and credits. There are separate accounts for each classification type such as cash, salaries expense, accounts payable, etc .

Double entry accounting According to Pacioli, “ Double-entry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In accounting terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.” Luca Pacioli Developer of Double-Entry Accounting, c1494 Scale or Balance Receive DEBIT Give CREDIT

Debits and Credits Two of the most familiar accounting terms are “debits and credits.” In the double-entry system, debits must always equal credits for the accounting equation. Debit (from the Latin word debere) means “left.” It is often abbreviated as “dr.” Credit (from the Latin word credere) means “right.” It is often abbreviated as “cr.” Recording done by debiting at least one account and crediting another. DEBITS must equal CREDITS .

Debits and Credits An arrangement that shows the effect of transactions on an account. Debit = “Left” Credit = “Right” Account An Account can be illustrated in a T-Account form.

Debits and Credits Account Name Debit / Dr. Credit / Cr. If Debit entries are greater than Credit entries, the account will have a debit balance. $10,000 Transaction #2 $3,000 $15,000 8,000 Transaction #3 Balance Transaction #1

Debits and Credits If Credit entries are greater than Debit entries, the account will have a credit balance. $10,000 Transaction #2 $3,000 $1,000 8,000 Transaction #3 Balance Transaction #1

Debits and Credits Summary Normal Balance Credit Normal Balance Debit

Debits and Credits Summary Balance Sheet Income Statement = + - Asset Liability Equity Revenue Expense Debit Credit

Basic Accounting Equation Relationship among the assets, liabilities and stockholders’ equity of a business: The equation must be in balance after every transaction. For every Debit there must be a Credit.

Ownership Structure Ownership structure dictates the types of accounts that are part of the equity section. Proprietorship or Partnership Corporation Capital Account Drawing Account Common Stock Additional Paid-in Capital Dividends Declared Retained Earnings

The Accounting Cycle Transactions 1. Journalization 6. Financial Statements 7. Closing entries 8. Post-closing trail balance 9. Reversing entries 3. Trial balance 2. Posting 5. Adjusted trial balance 4. Adjustments Work Sheet

Transactions and Events What to Record? FASB states, “transactions and other events and circumstances that affect a business enterprise.” Types of Events: External – between a business and its environment. Internal – event occurring entirely within a business.

Review “Transactions and Events” A supplier of a company‘s raw material is paid an amount owed on account. External Not Recorded 2. A customer pays its open account. External 3. A new chief executive officer is hired. Not Recorded 4. The biweekly payroll is paid. 5. Raw materials are entered into production. Internal External 6. A new advertising agency is hired. Not Recorded 7. The accountant determines the federal income taxes owed based on the income earned. Internal External Internal

Transactions are initially recorded (journalized) in chronological order before they are transferred to the ledger accounts. A journal makes several contributions to recording process: 1. Discloses in one place the complete effect of a transaction 2. Provides a chronological record of transactions 3. Helps to prevent or locate errors as debit and credit amounts for each entry can be compared THE JOURNAL

JOURNALIZING Entering transaction data in the journal is known as journalizing. Separate journal entries are made for each transaction. A complete entry consists of: 1. The date of the transaction, 2. The accounts and amounts to be debited and credited, 3. A brief explanation of transaction. 1. Journalizing

The date of the transaction is entered into the date column. The debit account title is entered at the extreme left margin of the Account Titles and Explanation column. The credit account title is indented on the next line. TECHNIQUE OF JOURNALIZING 1 Computer Equipment 7,000 Cash 7,000 (Purchased equipment for cash) GENERAL JOURNAL J1 Date Account Titles and Explanation Ref. Debit Credit 2005 Sept. 1 Cash 15,000 R. Neal, Capital 15,000 (Invested cash in business)

When three or more accounts are required in one journal entry, the entry is referred to as a compound entry. COMPOUND JOURNAL ENTRY 2 1 3

2. Posting Posting – the process of transferring amounts from the journal to the ledger accounts. General Ledger General Journal Jan. 3 Sale of stock GJ1 100,000 100,000 100 GJ1

3. Trial Balance Trial Balance – a list of each account and its balance; used to prove equality of debit and credit balances.

4. Adjusting Entries Adjustments (adjusting entries) - end-of-period entries that assign the financial effects of implicit transactions to the appropriate time periods. Adjustments are usually made when the financial statements are about to be prepared. Adjusting entries - needed to ensure that the revenue recognition and matching principles are followed. Revenues - Revenues are the economic resources flowing into a business as a result of operational activities (such as providing goods or services to other economic entities). Sales revenue, service revenue, and investment revenues are subdivisions of revenues. Increase in Revenues will increase Owner' Equity.

cont’d Expenses - Expenses are the outflow of a business’s economic resources resulting from the operational activities (such as purchasing goods or receiving services from other economic entities). They are the cost of doing business. Expenses can be termed in different ways according to the business activities. Cost of goods sold, administrative expenses, selling expenses, financial expenses are special terms of expenses. Increase in expenses will decrease owner' equity. Revenues and expenses are the subdivisions of Owner' Equity.

Classes of Adjusting Entries 1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. Prepayments 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. 2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned. Accruals

Payment of cash that is recorded as an asset because service or benefit will be received in the future. Adjusting Entries – “Prepaid Expenses” insurance supplies advertising Cash Payment Expense Recorded BEFORE rent maintenance on equipment fixed assets Prepayments often occur in regard to: Method: create Asset accounts to account for them.

Adjusting Entries – “Prepaid Expenses” Example: On Jan. 1 st , Phoenix Corp. paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the payment on Jan. 1 st . Cash 12,000 Prepaid insurance 12,000 Jan. 1 Debit Credit Prepaid Insurance 12,000 12,000 Debit Credit Cash

Adjusting Entries – “Prepaid Expenses” Example: On Jan. 1 st , Phoenix Corp. paid $12,000 for 12 months of insurance coverage. Show the adjusting journal entry required at Jan. 31 st . Prepaid insurance 1,000 Insurance expense 1,000 Jan. 31 Debit Credit Prepaid Insurance 12,000 1,000 Debit Credit Insurance expense 1,000 11,000

Receipt of cash that is recorded as a liability because the revenue has not been earned. Adjusting Entries – “Unearned Revenues” rent airline tickets school tuition Cash Receipt Revenue Recorded BEFORE magazine subscriptions customer deposits Unearned revenues often occur in regard to: Method: create a liability to account for it.

Adjusting Entries – “Unearned Revenues” Example: On Nov . 1 st , Phoenix Corp. received $24,000 from city School for 3 months rent in advance. Show the journal entry to record the receipt on Nov. 1 st . Unearned rent revenue 24,000 Cash 24,000 Nov. 1 Debit Credit Cash 24,000 24,000 Debit Credit Unearned Rent Revenue

Adjusting Entries – “Unearned Revenues” Example: On Nov. 1 st , Phoenix Corp. received $24,000 from city High School for 3 months rent in advance. Show the adjusting journal entry required on Nov. 30 th . Rent revenue 8,000 Unearned rent revenue 8,000 Nov. 30 Debit Credit Rent Revenue 8,000 24,000 Debit Credit Unearned Rent Revenue 8,000 16,000

Revenues Received in Advance The transactions regarding prepaid expenses and unearned revenues are really mirror images of each other. Liabilities (Unearned Revenues) Revenues Earned Seller Adjustments Buyer Assets (Prepaid Expenses) Expenses Incurred Adjustments Appear in Balance Sheet Appear in Income Statement Appear in Balance Sheet Appear in Income Statement

Revenues earned but not yet received in cash or recorded. Adjusting Entries – “Accrued Revenues” rent interest services performed BEFORE Accrued revenues often occur in regard to: Cash Receipt Revenue Recorded Adjusting entry results in: Method: Create an Asset Account to account for it.

Adjusting Entries – “Accrued Revenues” Example: On July 1 st , Phoenix Corp. invested $300,000 in securities that return 5% interest per year. Show the journal entry to record the investment on July 1 st . Cash 300,000 Investments 300,000 July 1 Debit Credit Investments 300,000 300,000 Debit Credit Cash

Adjusting Entries – “Accrued Revenues” Example: On July 1 st , Phoenix Corp. invested $300,000 in securities that return 5% interest per year. Show the adjusting journal entry required on July 31 st . Interest revenue 1,250 Interest receivable 1,250 July 31 Debit Credit Interest Receivable 1,250 1,250 Debit Credit Interest Revenue

Expenses incurred but not yet paid in cash or recorded. Adjusting Entries – “Accrued Expenses” rent interest taxes BEFORE Accrued expenses often occur in regard to: Cash Payment, if any* Expense Recorded salaries bad debts* Adjusting entry results in: Method: Create a Liability Account to account for it.

Adjusting Entries – “Accrued Expenses” Notes payable 200,000 Cash 200,000 Feb. 2 Debit Credit Cash 200,000 200,000 Debit Credit Notes Payable Example: On Feb. 2 nd , Phoenix Corp. borrowed $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the journal entry to record the borrowing on Feb. 2 nd .

Adjusting Entries – “Accrued Expenses” Example: On Feb. 2 nd , Phoenix Corp. borrowed $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the adjusting journal entry required on Feb. 28 th . Interest payable 1,500 Interest expense 1,500 Feb. 28 Debit Credit Interest Expense 1,500 1,500 Debit Credit Interest Payable

5. Adjusted Trial Balance Shows the balance of all accounts, after adjusting entries, at the end of the accounting period. Assets (Various) Unbilled Services Receivable Inventory Prepaid Rent Prepaid Insurance Buildings Equipment Land Liabilities (Various) Accrued Wages Payable Accrued Interest Payable Unearned Revenue Owner’s Equity Stock Retained Earnings

6. Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Statement of Cash Flows Statement of Retained Earnings

6. Preparing Financial Statements Balance Sheet Assume the following Adjusted Trial Balance

6. Preparing Financial Statements Income Statement Assume the following Adjusted Trial Balance

6. Preparing Financial Statements Statement of Retained Earnings Assume the following Adjusted Trial Balance

7. Closing Entries To reduce the balance of the income statement ( revenue and expense ) accounts to zero. To transfer net income or net loss to owner’s equity. Balance sheet ( asset , liability , and equity ) accounts are not closed. Dividends are closed directly to the Retained Earnings account.

7. Closing Entries Example : Assume the following Adjusted Trial Balance

7. Closing Entries Example: Prepare the Closing journal entry from the adjusted trial balance on the previous slide. Sales 185,000 Income summary 202,000 Interest income 17,000 Income summary 115,000 Cost of goods sold 47,000 Salary expense 25,000 Depreciation expense 43,000 Income summary 87,000 Retained earnings 87,000 Retained earnings 10,000 Dividends declared 10,000

By Hashim Khan BBA(Hons) IMStudies University Of Peshawar

Accounting cycle

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