CHAPTER 5

Completing the
Accounting Cycle
 Why Use Accrual Accounting?

Business Accrual-basis
requires
periodic, timely accounting
reporting. better
measures a
firm’s
performance
that does cash
flow data.
Define the Time Period Concept.

Time Period Concept—

the life of a business is
divided into distinct
and relatively short
time periods so the
accounting
information can be
timely, generally 12
months or less.
 Financial Reports
Most companies report to
stockholders at fiscal year-
end.
ABC Inc.
Annual Report Other reports are issued
more frequently, perhaps
monthly or quarterly.

This frequency of reports

forces accountants to use
data based on judgments
and estimates.
 Define Accrual Accounting

A system of accounting in which

revenues and expenses are
recorded as they are earned and
incurred, not necessarily when
cash is received or paid.
Provides a more accurate picture of
a company’s profitability.
Statement users can make more
informed judgments concerning
the company’s earnings potential.
 Revenue Recognition

Revenues are recorded when two main

criteria are met: What are they?

The earning process is

substantially complete

Cash has either been

collected or collection
is reasonably assured.
 Define The Matching Principle
All costs and expenses
costs and expenses incurred in generating
revenues must be
recognized in the same
reporting period as the
related revenues.
This process of matching
expenses with recognized
revenues determines the
amount of net income
related revenues
reported on the income
statement.
 Define Cash-Basis Accounting

Revenues and expenses

are recognized only
when cash is received
or payments are made.
Mainly used by small
businesses.
Not an accurate picture
of true profitability.
 Example: Accrual- vs. Cash-Basis
Accounting
During 2006, Crown Consulting billed its client for
$48,000. On December 31, 2006, it had received
$41,000, with the remaining $7,000 to be received in
2007. Total expenses during 2006 were $31,000
with $3,000 of these costs not yet paid at December
31. Determine net income under both methods.

Crown Consulting
Reported Income for 2006
Cash-Basis Accounting Accrual-Basis Accounting
Cash receipts $41,000 Revenues earned $48,000
Cash disbursement 28,000 Expenses incurred 31,000
Income $13,000 Income $17,000
 Why DO Adjusting Entries?

Adjusting entries are required at

the end of each accounting period
for accrual-basis accounting, prior
to preparing the financial
statements.
• To bring balance sheet accounts
current.
• To reflect proper amounts of
revenues and expenses on the
Income Statement.
 Adjusting Entries Tips

Each adjusting entry

always involves at least
one income statement
account and one balance
sheet account.

Adjusting entries never involve cash.

 Define Each of These Common
Adjusting Entries

Unrecorded Revenues earned but not yet recorded by

Receivables period’s end.
Always debit
Always debit
Unrecorded Expenses incurred but an not
Expense &
yet recorded
Unrecorded
a Receivable
Liabilities Receivables &
by period’s end. credit a
& credit a
Liabilities will have no for
Prepaid Liability
Revenue for original
Payments entries.
made in advance for items
Expenses unrecorded
unrecorded normally charged to expense.
Unearned liabilities
receivablesAmounts received before the actual
Revenues
earning of revenues.
 What Is the 3-Step Process for
Adjusting Entries?

1. Identify the original entries that

were made (original entries are
only made for unearned revenues
and prepaid expenses).
2. Determine what the correct
balances should be at this point in
time.
3. Make the adjustments needed to
correct the balances.
 Example: Unrecorded Receivables
Bullseye Management earns a rent revenue
of $500 in 2006 but will not receive the
payment until January 10, 2007. An
adjustment will be needed. What is the
adjusting entry?
Rent Receivable Rent Revenue
Original entry none none

Correct balances 500 500

12/31/06 Rent Receivable 500

Rent Revenue 500
 Example: Unrecorded Liabilities
MoneyTree Inc. is assessed property
taxes of $1,000 for 2006, but will not make
this payment until January 5, 2007. An
adjustment will be needed. What is the
adjusting entry?
Property Tax Property Tax
Expense Payable
Original entry none none

Correct balances 1,000 1,000

12/31/06 Property Tax Expense 1,000

Property Tax Payable 1,000
 Example: Prepaid Expenses
On July 1, 2006, I Think I Can Inc. pays
$3,600 for one year’s rent in advance
(covering July 1, 2006, to June 30, 2007).
On December 31, 2006, an adjustment will
be needed. What is the adjusting entry?
Prepaid
Rent Expense Cash Rent
Original entry 3,600 3,600
Adjusting entry 1,800 1,800
Correct balances 1,800 1,800

12/31/06 Prepaid Rent 1,800

Rent Expense 1,800
 Example: Advanced Revenues
On July 1, 2006, Clean As A Whistle Co.
received $3,600 for one year’s rent in
advance (covering July 1, 2006, to June 30,
2007). On December 31, 2006, an
adjustment will be needed. What is the
adjusting entry?
Advanced
Rent Revenue Cash Rent

Original entry 3,600 3,600

Adjusting entry 1,800 1,800

Correct balances 1,800 1,800

12/31/06 Rent Revenue 1,800

Advanced Rent 1,800
 Preparing
Financial Statements
Prepared directly from
the data in the
adjusted ledger
accounts.
Explanatory notes
clarify the methods
and assumptions.
The auditor reviews
the statements with
GAAP.
 Describe the Preparation of
Financial Statements

The information is taken from the trial balance

Steps:
1. Identify Revenue and Expense accounts, they are
used to produce the income statement
2. Compute Net Income, Revenues – Expenses
3. Compute Ending Retained Earnings (Chap. 2)
4. Prepare Balance Sheet using Trial Balance accounts
that are not identified in Step 1, remember to use
Ending Retained Earnings from Step 3
 What Are The Notes and Why
Have Them?

List assumptions and

methods used in
preparing financial
statements.
Give more detail about
specific items.
Serve to augment the
summarized, numerical
information.
 Tell Me About The Audit

Audits statements to check

conformity with GAAP.
Reviews adjustments.
Samples selected accounts.
Reviews accounting
systems.
Attaches report and
distributes it with financial
statements.
 Using a Work Sheet

What Is a Work Sheet? How Does It Work?

A columnar schedule First list the trial
used to summarize balance.
accounting data. Then add any
For internal use only. adjusting entries.
Helpful for organizing Extend the combined
large quantities of amounts to the
data. appropriate
statement columns.
Most use computer
Add a balancing
spreadsheets.
figure if debits do
not equal credits.
 Learning Objective 4

Complete the closing

process in the
accounting cycle.
 Describe The Closing Process

Real Accounts Nominal Accounts

Temporary accounts
Report the cumulative (revenues, expenses,
increases and decreases and dividends) are
in balance sheet closed to a zero
accounts from the date of balance at the end of
organization. each period.
At period’s end,
Permanent; they are not
adjustments are
closed to a zero balance made, the income
at the period’s end. statement is prepared,
Balances are carried and balances are then
closed to Retained
forward to next period.
Earnings.
 Closing Entries Identify Nominal
and Real Accounts

Dec. 31 Sales Revenue. . . . . . . . . . . 1,500

Rent Revenue. . . . . . . . . . . . 100
nominal or
temporary Cost of Goods Sold . . . . . 1,100
accounts
Salaries Expense. . . . . . . 200
Other Expenses . . . . . . . . 150
Retained Earnings . . . . . . 150

real (permanent) account

 Closing Entries Describe Which
Accounts Are Used For Each
Entry
Step 1. Close all revenue accounts by debiting
them.
Sales Revenue. . . . . . . . . 15,000
Retained Earnings . . . . 15,000
Step 2. Close all expense accounts by crediting
them.
Retained Earnings. . . . . . . 13,600
Cost of Goods Sold. . . . 12,800
Insurance Expense. . . . 500
Supplies Expense. . . . . 300
 Closing Dividends
Discuss the Dividends Account

Dividends
a nominal account
not an expense
distributions to stockholders of part of the
corporation’s earnings
reduces Retained Earnings
are declared and paid
To close, credit Dividends and debit Retained
Earnings.
 Make All Three Dividends
Entries for $200
Declaration of Dividends:
Dividends. . . . . . . . . . . . . . . 200
Dividends Payable . . . . . . 200

Payment of Dividends:
Dividends Payable . . . . . . . 200
Cash . . . . . . . . . . . . . . . . 200

Closing Entry for Dividends:

Retained Earnings . . . . . . . 200
Dividends . . . . . . . . . . . . 200
 The Closing Process
Revenues
Revenues Retained Earnings
xxx Bal. xxx Beg. Bal. xxx

Revenues

Since the revenues account is

Expenses Dividends
a nominal account, it is closed
Bal. xxx Bal. xxx
at the end of the period to
Retained Earnings.
 The Closing Process Expenses
Retained Earnings
Revenues Beg. Bal. xxx
xxx Bal. xxx Expenses Revenues

The expenses account is

Expenses also a nominal account
Dividends
and is debited to
Bal. xxx xxx Bal. xxx
Retained Earnings to
close it.
 The Closing Process Dividends
Revenues Retained Earnings
Bal. xxx
xxx Beg. Bal. xxx
Expenses Revenues
The dividends
account, which is also Dividends
nominal, is credited to
close out the balance.
Expenses Dividends
Bal. xxx Bal. xxx
xxx xxx
 The Closing Process
Revenues Retained Earnings
Bal. xxx Beg. Bal. xxx
xxx
Retained Earnings
Expenses Revenues
is a real account
Dividends
and always carries a
End. Bal. xxx
balance.

NetExpenses
income for the Dividends
period
Bal. xxx
is determined Bal. xxx
by these twoxxx entries. xxx
 Post-Closing Trial Balance

Optimal last step.

Information taken from the General Ledger
after all closing entries are posted.
Lists all real account balances at the end of
the closing process.
Assures that total debits equal total credits
prior to the beginning of the new
accounting period.
Only real accounts will have a balance at this
time.
 Example: Post-Closing
Trial Balance
Three Monkeys Inc.
Post-Closing Trial Balance
December 31, 2006
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
 Summary of the
Accounting Cycle

Financial statements:
Result from the accounting cycle.
Provide useful information to
investors, creditors, and other users.
Are included in the annual reports
provided to stockholders.
Can be analyzed and compared to
statements of similar firms to detect
strengths and weaknesses.