SUMMARY
Topic: Accounting Cycle
Learning outcomes: Explain how the timeliness, matching, and recognition GAAP require
the recording of adjusting entries. Explain the use of and prepare the adjusting entries
required for prepaid expenses, depreciation, unearned revenues, accrued revenues, and
accrued expenses. Identify and explain the steps in the accounting cycle. Prepare an
adjusted trial balance and use it to prepare financial statements.
KEY CONCEPTS
Adjusting journal entries: to achieve a proper matching of costs and expenses with
revenue, we must adjust the account balances at the end of each accounting period before
financial statements are prepared to reflect what has been earned and expensed in the
period (income statement) and what remains to be used or paid in future terms (balance
sheet).
Deferred costs: recognizing expense in a future period despite cash was paid and
recorded.
Accrue expenses: recognizing expense in the current period even before cash is paid.
Accrue revenue: recognizing revenue in this period even before cash is received.
Deferred revenue: recognizing revenue in a future period despite cash was received and
recorded.
Trial balance: lists all accounts and report their ending balances. If done before Adjusting
Journal entries it is an unadjusted trial balance; if done after AJE, it is an adjusted trial
balance. A balanced trial balance simply proves that as recorded, debits equal credits.
Sequence of financial statement preparation: prepare the income statement first, the
bottom line of this statement (net income or loss) is needed to prepare the Statement of
Owner's Equity. The new total in this second statement is then used in the Owner’s Equity
section of the Balance Sheet. The linkage of these three statements is called "articulation".
Proprietorship: The simplest form of organization, in which a single individual, who typically
also manages the business, owns an unincorporated business.
Proprietorships do not report income taxes on their income statements and show only a
single amount, called Owner’s or Proprietor’s Equity or Capital, on their balance sheet.
Corporation: is a separate legal entity distinct from its owners, its shareholders. A
corporation issues shares to raise capital. The liability of a shareholder is limited to their
investment in the shares of the corporation. The balance sheet reports amounts received
from share issue (Share Capital or Capital Stock) separately from Retained Earnings - the
accumulated earnings from the time the corporation began, less the total of any distributions
to shareholders (Dividends).
Partnership: is an agreement between partners who have unlimited liability. It is now
possible to form Limited Liability Partnerships so that the liability of all but a general partner
is more limited. Tax and accounting treatments are similar to a proprietorship.
eBook End of Chapter 4 – Activities recommended
Problem 02 and prepare the adjusted trial balance as an additional requirement (c)
Problem 05
CORE TEMPLATES
Deferred costs: recognizing expense in a future period despite cash being paid and
recorded. Original Journal entry (minimum of 2 accounts involved, it might have more).
Always Dr = Cr.
AJE - Adjusting Journal entry (minimum of 2 accounts involved, it might have more). Always
Dr = Cr.
T account and posting of original journal entries and AJE (Account name (1) rent expense is
adjusted).
Accrue expenses: recognizing expense in the current period even before cash is paid.
Original Journal entry (minimum of 2 accounts involved, it might have more). Always Dr = Cr
AJE - Adjusting Journal entry (minimum of 2 accounts involved, it might have more). Always
Dr = Cr.
T account and posting of original journal entries and AJE (Account name (1) Prepaid Rent is
adjusted, and the Rent Expense is recognized at the end of the month when there are no
more days of prepaid rent).
LECTURE
Income statement (Revenue - Expenses = Net Income) →Statement of changes in equity:
Beginning Balance + Net Income - Dividends Paid = Ending Balance. → Balance Sheet: List
of assets and liabilities at end of reporting period. → Cash flow statement.
Example: GLORIOUS GLASS CO
1. The owner invests $4,000 (+Assets).
Entry: Dr Cash 4000 Cr Owner’s Equity 4000 (+OE).
Notes: Debits come first. Credits come after all debits and are indented to the right. Orders
within debits/credits do not matter.
2. Pays the landlord three months' rent, $750.
Entry: Dr Prepaid Rent 750 Cr Cash 750.
3. Pays for a furnace (needed to melt the sand to make the glass) $2,000.
Entry: Equipment 2000 Cr Cash 2000.
4. Pays for supplies $1000.
Entry: Supplies 1000 Cr Cash 1000.
5. Purchases Fuel on account $700.
Entry: Fuel supply 700 Cr Accounts Payable 700.
6. Cash Sales $5,000
← (+ OE)
7. Credit Sales $25,000.
Entry: Dr Accounts receivable 25000 Cr Revenue (+ OE) 250000.
*Why credit “Revenue” instead of “Sales” or “Sales Revenue”? Synonyms in accounting
Importance of using the exact wording specified in the Chart of Accounts (or the exam
question).
8. Collects from Customers $6,000
Entry: Dr Cash 6000 Cr Accounts receivable 6000.
9. Receives advances from customers of $3,000.
Entry: Dr Cash 3000 Cr Unearned revenue 3000.
10. Pay creditors on account $700
Entry: Dr Accounts payable 700 Cr Cash 700.
Adjust the account balances to achieve a proper matching of costs and expenses with
revenue each period.
At period end, before financials can be prepared: • Deferred costs and revenues on the B/S
may need potential allocation to the I/S • Revenues earned and costs incurred but not yet set
up must be properly accrued.
Accrue – • recognize expense or revenue in the current period • Cash is exchanged in a
future period.
Defer – • put off recognizing expense or revenue • Cash has already been exchanged.
Deferred Cost Example
• If three months' rent is paid on the first of the month and is initially recorded as an asset.
Aug 1: Dr Prepaid Rent
$ 750
Cr Cash
$ 750
• and the rent for the month is $250, then the adjusting entry is:
Aug 31: Dr Rent expense
$ 250
Cr Prepaid Rent
$ 250
Sep 30: Dr Rent expense
$ 250
Cr Prepaid Rent
$ 250
Oct 31: Dr Rent expense
$ 250
Cr Prepaid Rent
$ 250 ← Matching Principle.
Deferred Revenue Example
If a deposit from a customer was initially recorded as a liability:
Sep 1: Dr Cash $3,000
Cr Unearned Revenue
$3,000
• And a third of it was earned during the period. Then the adjusting entry is:
Sep 30 Dr Unearned Revenue $ 1,000
Cr Revenue
$ 1,000
Oct 31 Dr Unearned Revenue $ 1,000
Cr Revenue
$ 1,000
Nov 30 Dr Unearned Revenue $ 1,000
Cr Revenue
$ 1,000 ← Revenue Recognition.
Accrued Revenue Example
Rent revenue from the tenant is collected in the first week of the following month.
The monthly rent is $1500.
• At the end of each month:
Aug 31 Dr Rent Receivable 1500
Cr Rent Revenue
1500
Sept 7 Dr Cash 1500
1500 Cr Rent Receivable
1500
Accrued Expense Example
Telephone bill is received at the end of each month, and the payment is due by the 15th of
the following month. The monthly telephone bill is $100.
• At the end of each month:
Aug 31 Dr Telephone/Utility exp 100
Cr Telephone/Utility payable 100
Sept 15 Dr Telephone/Utility payable 100
Cr Cash 100
Depreciation
✓Classic example of an adjusting entry
✓Any asset with multi-period utility to create revenue streams is initially recorded on the
Balance Sheet as an asset (unexpired benefit)
✓Each period some of that utility is consumed and we must recognize this by transferring
part of it from the Balance Sheet asset (the place for unexpired costs with future utility) to
the Income Statement as expense (where we send expired costs)
✓Journal entry:
DR Depreciation Expense
CR Accumulated depreciation
To comply with historical cost principle and full disclosure, instead of directly decreasing the
value of the asset, an accumulated dep A/C is created as a contra.
Income Statement Glorious Glass
Balance Sheet GGC
CASH FLOW STMT IS ALSO A “PROOF” OF CASH
Opening Balance Cash + – Change in cash for the period = Ending Balance Cash.
As we will see in Chapter 12, when we learn how to prepare the cash flow statement,
everything in the statement comes from the Cash ledger account…the cash flow statement
is nothing more than a reformatted cash ledger account with cash flows grouped to make
them more meaningful. Note that you only need to know how to read a Cash Flow Statement
for now. On the final exam, you will be asked to prepare one.