CHAPTER
4
Completing the
Accounting Cycle
Learning Objective 1
Describe how
accrual
accounting
allows for timely
reporting and a
better measure of
a company's
economic
performance.
Why Use Accrual Accounting?
Business
requires
periodic, timely
reporting.
Accrual-basis
accounting
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
ABC Inc.
Annual Report
Most companies report to
stockholders at fiscal yearend.
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
costs and expenses
All 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
reported on the income
related revenues
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 2002, Crown Consulting billed its client for
$48,000. On December 31, 2002, it had received
$41,000, with the remaining $7,000 to be received in
2003. Total expenses during 2002 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 2002
Cash-Basis Accounting
Cash receipts
$41,000
Cash disbursement
28,000
Income
$13,000
Accrual-Basis Accounting
Revenues earned
$48,000
Expenses incurred 31,000
Income
$17,000
Learning Objective 2
Explain the need for
adjusting entries and
make adjusting entries
for unrecorded
receivables,
unrecorded liabilities,
prepaid expenses, and
unearned revenues.
What Are the Steps in the
Accounting Cycle?
1. Analyze transactions and business
documents.
2. Journalize transactions.
3. Post journal entries to ledger accounts.
4. Determine account balances and prepare
a trial balance.
5. Journalize and post adjusting entries.
6. Prepare financial statements.
7. Journalize and post closing entries.
8. Balance the accounts and prepare a
post-closing trial balance.
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
Receivables
recorded by period’s
end.debit
Always
Always debit
anbut
Expense
&
Unrecorded
Expenses
incurred
not
yet
a Receivable
Unrecorded Receivables &
credit
a
Liabilities
recorded
by
period’s
end.
& credit
a
Liabilities
will have
no
Liability
for
Revenue for
Prepaid
original entries.
Payments
made inunrecorded
advance for
unrecorded
Expenses
items normally charged
to expense.
liabilities
receivables
Unearned
Amounts 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 2002 but will not receive the
payment until January 10, 2003. An
adjustment will be needed. What is the
adjusting entry?
Rent Receivable
Original entry
Correct balances
Rent Revenue
none
none
500
Adjusting entry: 12/31/02 Rent Receivable
Rent Revenue
500
500
500
Example: Unrecorded Liabilities
MoneyTree Inc. is assessed property
taxes of $1,000 for 2002, but will not make
this payment until January 5, 2003. An
adjustment will be needed. What is the
adjusting entry?
Property Tax
Expense
Original entry
Property Tax
Payable
none
none
Correct balances 1,000
1,000
Adjusting entry: 12/31/02Property Tax Expense 1,000
Property Tax Payable
1,000
Example: Prepaid Expenses
On July 1, 2002, I Think I Can Inc. pays
$3,600 for one year’s rent in advance
(covering July 1, 2002, to June 30, 2003).
On December 31, 2002, an adjustment will
be needed. What is the adjusting entry?
Prepaid Rent
Original entry
3,600
Adjusting entry
Correct balances
3,600
1,800
1,800
Cash
Rent
Expense
1,800
1,800
Adjusting entry: 12/31/02 Rent Expense
1,800
Prepaid Rent
1,800
Example: Unearned Revenues
On July 1, 2002, Clean As A Whistle Co.
received $3,600 for one year’s rent in
advance (covering July 1, 2002, to June 30,
2003). On December 31, 2002, an adjustment
will be needed. What is the adjusting entry?
Rent Revenue
Original entry
Cash
Unearned
Rent
3,600
Adjusting entry
1,800
Correct balances
1,800
Adjusting entry: 12/31/02 Unearned Rent
Rent Revenue
3,600
1,800
1,800
1,800
1,800
Learning Objective 3
Explain the
preparation of
the financial
statements, the
explanatory
notes, and the
audit report.
Review The Steps in the
Accounting Cycle
1. Analyze transactions and business
documents.
2. Journalize transactions.
3. Post journal entries to ledger accounts.
4. Determine account balances and prepare
a trial balance.
5. Journalize and post adjusting entries.
6. Prepare financial statements.
7. Journalize and post closing entries.
8. Balance the accounts and prepare a
post-closing trial balance.
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.
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.
Learning Objective 4
Perform a
systematic
analysis of
financial
statements.
What Does The DuPont
Framework Do?
Summarizes the financial health of a company.
Systematic approach for breaking down ROE
into three ratios:
1. Profit margin (measure of profitability)
2. Asset turnover (measure of efficiency)
3. Assets-to-equity ratio (measure of
leverage)
What Are the Components of
ROE?
Return on Equity =
Net Income
Equity
Profitability x Efficiency
Profit Margin x
Net Income
Revenue
Asset
Turnover
x Revenue
Assets
x
Leverage
x Assets-toEquity Ratio
x
Assets
Equity
Common-Size Financial Statements
Divide all financial statement numbers for a given
year by the total revenues for the year.
All amounts are then shown as a percentage of
revenues for that year.
Helps to pinpoint problem areas.
Uncommon Company
Common-Size Income Statement
For the Year Ended 12/31/02
Revenues. . . . . . . . . . . . . . . .
Cost of sales. . . . . . . . . . . .
Selling & admin. exp. . . . . .
Income before taxes. . . . . . . .
Income tax expense. . . . . . . .
Net income. . . . . . . . . . . . . . .
$10,000
5,000
1,500
$ 3,500
1,000
$ 2,500
100%
50
15
35%
10
25%
Learning Objective 5
Complete the closing
process in the
accounting cycle.
Describe The Closing Process
Real Accounts
Report the cumulative
increases and decreases
in balance sheet
accounts from the date of
organization.
Permanent; they are not
closed to a zero balance
at the period’s end.
Balances are carried
forward to next period.
Nominal Accounts
Temporary accounts
(revenues, expenses,
and dividends) closed
to a zero balance at
the end of each
period.
At period’s end,
adjustments are
made, the income
statement is prepared,
and balances are then
closed to Retained
Earnings.
Closing Entries Identify Nominal
and Real Accounts
Dec. 31 Sales Revenue. . . . . . . . . . . 1,500
Rent Revenue. . . . . . . . . . . .
nominal or
temporary
accounts
100
Cost of Goods Sold . . . . .
1,100
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 the Dividends Account
Discuss the Dividends Account
Dividends
a nominal account
not expenses
distributions to stockholders of part
of the corporation’s earnings
reduce 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 . . . . . . .
Cash . . . . . . . . . . . . . . . .
200
Closing Entry for Dividends:
Retained Earnings . . . . . . .
Dividends . . . . . . . . . . . .
200
200
200
The Closing Process
Revenues
Retained
Earnings
Bal. xxx
xxx
The dividends
is account,
a real account
which is
and
always
carries
also nominal, is
a balance.
credited to close
Retained Earnings
Beg. Bal. xxx
Expenses Revenues
Dividends
End. Bal. xxx
out the balance.
Since the revenues account is
account is
Expenses
nominal
it isDividends
closed
Neta
income
foraccount,
theThe expenses
alsoperiod
aBal.
nominal
account
at the
end
of
the
to
period
is determined
Bal.
xxx
xxx
xxx
xxx
and is debited to Retained
Retained
Earnings.
by these
two entries.
Earnings to close it.
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, 2002
Debits
Credits
Cash
$ 8,200
Accounts Receivable 4,000
Inventory
3,000
Supplies
1,000
Accounts Payable
Capital Stock
Retained Earnings
______
Totals
$16,200
$ 5,000
10,000
1,200
$16,200
Learning Objective 6
Understand how all
the steps in the
accounting cycle
fit together.
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.
Learning Objective 7
Expanded Material
Make adjusting entries for
prepaid expenses and
unearned revenues when
the original cash amounts
are recorded as expenses
and revenues.
Example: Prepaid Expenses
On July 1, 2002, Time Flies Company pays $3,600
for one year’s rent in advance (covering July 1,
2002, to June 30, 2003). On December 31, 2002, an
adjustment will be needed. What is the adjusting
entry using the expense approach?
Prepaid Rent
Original entry
Adjusting entry
Cash
Rent Expense
3,600 3,600
1,800
1,800
Correct balances 1,800
1,800
Adjusting entry: 12/31/02 Prepaid Rent
1,800
Rent Expense
1,800
Example: Prepaid Expenses
On July 1, 2002, Pot Of Gold Inc. pays the
Rainbow Company $3,600 for one year’s rent in
advance (covering July 1, 2002, to June 30,
2003). On December 31, 2002, an adjustment
will be needed. Use the revenue approach.
Rent Revenue
Original entry
Adjusting entry
Correct balances
Cash
Unearned
Rent
3,600 3,600
1,800
1,800
1,800
1,800
Adjusting entry: 12/31/02 Rent Revenue
1,800
Unearned Rent
1,800
Appendix A: Using a Work Sheet
What Is a Work
Sheet?
A columnar schedule
used to summarize
accounting data.
For internal use only.
Helpful for
organizing large
quantities of data.
Most use computer
spreadsheets.
How Does It Work?
First list the trial
balance.
Then add any
adjusting entries.
Extend the combined
amounts to the
appropriate
statement columns.
Add a balancing
figure if debits do
not equal credits.
Appendix B: Special Journals
Sales Journal
Cash Receipts Journal
Record credit sales at
their gross amounts,
noting discounts at the
time of collection (in
the Cash Receipt
Journal).
Record all cash received
from sales, interest, rent,
or other sources.
Purchases Journal
Cash Disbursements
Journal
Record credit
purchases. At period’s
end, post total to both
Accounts Payable and
Purchases.
Record all cash paid out
for supplies,
merchandise, salaries,
and other items.
END CHAPTER 4