Chapter 4

The Accounting Cycle Adjusting Entries Closing Process Net Profit Margin Ratio

The Accounting Cycle

Accounting cycle process
Records individual transactions Produces the four basic financial statements Gets the general ledger ready for the next accounting period Made up of eight steps

Accounting Cycle Steps

Record journal entries from transactions Post journal entries to the general ledger Prepare unadjusted trial balance Adjust the accounts Prepare an adjusted trial balance Prepare the financial statements Close the temporary accounts Prepare a post-closing trial balance

Unadjusted Trial Balance

A listing of individual accounts, usually in financial statement order.

Ending debit or credit balances are listed in two separate columns. Total debit account balances should equal total credit account balances.

Unadjusted Trial Balance Example

Matrix, Inc. Unadjusted Trial Balance At December 31, 2006 Description Cash Accounts receivable Inventory Equipment Accumulated depreciation - Equip. Furniture and fixtures Accumulated depreciation - furn. & fix. Accounts payable Notes payable Common stock Retained earnings, 12/31/05 Sales revenue Cost of goods sold Operating expenses Totals $ Debit 3,900 4,985 3,300 4,800 $ 6,600 2,200 2,985 4,000 10,000 1,760 35,000 27,500 6,300 $ 57,385 $ 57,385 1,440 Credit

Problem
Following unadjusted account balances for Delilahs Deluxe Doggie Dayspa: Delilah's Deluxe Doggie Dayspa Unadjusted Trial Balance December 31, 2005

Cash Accounts Receivable Supplies Prepaid Rent Prepaid Insurance Notes Receivable (due 3/31/04) Equipment Accounts Payable Unearned Service Revenue Notes Payable (due 5/1/07) Common Stock Dividends Service Revenue Salary Expense Rent Expense Income Tax Expense Required: Prepare a trial balance in good form.

13,500 14,000 3,500 24,000 12,000 30,000 245,000 12,500 20,000 100,000 50,000 12,000 367,500 165,000 20,000 11,000

The Unadjusted Trial Balance

If total debits do not equal total credits on the trial balance, errors have occurred . . .
in preparing balanced journal entries, in posting the correct dollar effects of a transaction, or in copying ending balances from the ledger to the trial balance.

Adjusting Entries
ACCRUALS Revenues earned or expenses incurred that have not been previously recorded.

There are two types of adjusting entries.

DEFERRALS Receipts of assets or payments of cash in advance of revenue or expense recognition.

Deferred Revenue
End of accounting period.

Cash received.

Revenues earned.

Example includes rent received in advance (an unearned revenue).

Accrued Revenue
End of accounting period.

Revenues earned

Cash received

Example includes interest earned during the period (accrued revenue).

Deferred Expense
End of accounting period.

Cash paid.

Expense incurred.

Examples include prepaid rent, advertising, and insurance.

Accrued Expense
End of accounting period.

Expense incurred.

Cash paid.

Examples include salaries and wages incurred but not recorded.

Adjustments Involving Estimates

Certain circumstances require adjusting entries to record accounting estimates. Examples include . . .
Depreciation Bad debts Income taxes

$$$

Depreciation Adjustment
The accounting concept of depreciation involves the systematic and rational allocation of the cost of a longlived asset over multiple accounting periods it is used to generate revenue.

This is a cost allocation concept, not a valuation concept.

Prepare the Adjusted Trial Balance

After weve completed and posted the adjusting entries to the general ledger accounts, we prepare another trial balance We confirm again that the debit balances equal the credit balances Basis for preparing the financial statements

Problem
Prepare adjusting entries from the following information:
a) An inventory of supplies reveals that $1,300 of supplies are on hand. (deferred expense/ asset) b) Delilahs has a 6 day work week, Monday through Saturday. (accrued expense/ liability) Employees are paid every Friday. 12/31 is on a Tuesday. Delilahs weekly payroll is $3,600. c) The equipment was purchased 1/1/05. (deferred expense/ asset) It has an expected life of 10 years and no salvage value. d) The note receivable was issued by a client on 10/31/05. (accrued revenue/ asset) The annual interest rate is 7%. e) The note payable was issued 4/1/05. The annual interest rate is 5%. (accrued expense/ liability) f) Unearned service revenue represents gift certificates purchased. (Deferred revenue/ liability) At year end, $8,000 of the certificates have been used. g) Prepaid insurance represents a payment of $12,000 for 2 years coverage. (deferred expense/ asset) The payment was made 7/1/05. h) Prepaid rent represents a payment of $24,000 for 12 months rent. (deferred expense/ asset) The payment was made 9/1/05.

Problem

Post these journal entries to the t-accounts and prepare an adjusted trial balance.

Prepare the Financial Statements

Goal of the whole process Financial statements that reflect the financial condition and transactions of the company
Income Statement Statement of Changes of Owners Equity Balance Sheet Statement of Cash Flows

Problem

From the adjusted trial balance for Delilahs, prepare an income statement, statement of stockholders equity, & classified balance sheet.
For computing the EPS, assume 10,000 shares are outstanding.

Closing the Books

Closing entries: Even though the 1. Transfer net income balance sheet (or loss) to Retained account balances Earnings. carry forward 2. Establish a zero from period to balance in each of the period, the temporary accounts to income statement start the next accounts do not. accounting period.

Closing the Books

The following accounts are called temporary or nominal accounts and are closed at the end of the period . .. Revenues.
Expenses. Gains. Losses. Dividends declared.

Closing the Books

Assets, liabilities, and stockholders equity are permanent, or real accounts, and are never closed.
Assets.

Liabilities.
Stockholders

Equity.

Closing the Books

Two steps are used in the closing process . ..
1. Close revenues and gains to Retained Earnings. 2. Close expenses and losses to Retained Earnings.

Post-Closing Trial Balance

Prepared after the temporary accounts are closed Serves as a final check that debits = credits Confirms that we start the next accounting period with only permanent accounts

Post-Closing Trial Balance

Matrix, Inc. Adjusted Trial Balance At December 31, 2004 Description Debit Credit Cash $ 3,900 Accounts receivable 4,985 Inventory 3,300 Equipment 4,800 Accumulated depreciation - Equip. $ 1,440 Furniture and fixtures 6,600 Accumulated depreciation - furn. & fix. 2,200 Accounts payable 2,985 Notes payable 4,000 Common stock 10,000 Retained earnings, 1/1/04 1,760 Sales revenue 35,000 Cost of goods sold 27,500 Operating expenses 6,300 Totals $ 57,385 $ 57,385

Post-Closing Trial Balance

Matrix, Inc. Post-Closing Trial Balance At December 31, 2004 Description Cash $ Accounts receivable Inventory Equipment Accumulated depreciation - Equip. Furniture and fixtures Accumulated depreciation - furn. & fix. Accounts payable Notes payable Common stock Retained earnings, 12/31/04 Sales revenue Cost of goods sold Operating expenses Totals Debit 3,900 4,985 3,300 4,800 $ 6,600 2,200 2,985 4,000 10,000 2,960 1,440 Credit

$ 23,585 $ 23,585

Key Ratio Analysis

Net Profit Margin indicates how effective management is at generating profit on every dollar of sales.
Net Profit = Margin Net Income Net Sales

Problem

Prepare closing entries and post-closing trial balance for Delilahs. Prepare net profit margin for Delilahs.