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Completing the Accounting Cycle

Completing the Accounting Cycle Lecture Four Prepare and use an accounting work sheet to complete the accounting cycle Close the revenue, expense and drawings accounts Correct typical accounting errors Reversing Entries Classify Assets & Liabilities

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Completing the Accounting Cycle

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  1. Completing the Accounting Cycle Lecture Four CRICOS Provider Code 00301J

  2. Prepare and use an accounting work sheet to complete the accounting cycle Close the revenue, expense and drawings accounts Correct typical accounting errors Reversing Entries Classify Assets & Liabilities Use the current and debt ratios to evaluate a business Other Issues Profit Recognition Measurement Disclosure Learning Objectives CRICOS Provider Code 00301J

  3. The accounting cycle is the process by which accountants produce the financial statements for a specific period of time Work is performed at two different times: During the period journalising transactions and posting to the ledger End of the period Adjusting entries Closing entries Preparing financial statements Objective 1: Accounting Work Sheet CRICOS Provider Code 00301J

  4. A multi-column document, a work sheet, summarizes the effects of all the period’s activity Facilitates the calculation of periodic profit/loss Convenient device for completing the accounting cycle It is NOT a journal or ledger Actual adjustments of the accounts MUST be journalised and posted to the accounts It is an internal document only – it is NOT an auditable legal document Closing entries can also be prepared at this time Work Sheet CRICOS Provider Code 00301J

  5. Worksheet CRICOS Provider Code 00301J

  6. Work Sheet – Entering Adjusting Entries • Enter the following adjusting entries • Sales earned for the period is $10,000 Dr Sales 5,000 Cr Unearned Revenue 5,000 • Wages owing but not paid $2,500 Dr Wages Expense 2,500 Cr Accrued Wages 2,500 • Doubtful debts are estimated to be $750 Dr Doubtful Debts Expense 750 Cr Allowance for Doubtful Debts 750 CRICOS Provider Code 00301J

  7. Worksheet CRICOS Provider Code 00301J

  8. Worksheet CRICOS Provider Code 00301J

  9. Closing the accounts is the end of period process that prepares the accounts for recording transactions during the next period. Revenues, expenses, drawings and increments to capital represent increases and decreases in owner’s equity during a specific period At the end of an accounting period nominal (temporary) accounts are closed out – returned to a zero balance : . . . Only permanent accounts remain open and their balances carried forward to the next period : . . Follows the going concern, time period and matching principles Objective 2: Closing Entries CRICOS Provider Code 00301J

  10. Closing Entries • Close ALL revenue and expense accounts to the Income Summary Account (Profit and Loss Summary Account) • Close Income Summary Account (net profit/loss) to Owners Equity • Close drawings to Owners Equity CRICOS Provider Code 00301J

  11. Closing Entries • Refer Worksheet Example (Slide 8) • Sales revenue 10,000 Income Summary 10,000 • Income Summary 3,495 Telephone exp. 245 Wages exp. 2,500 Doubtful debts exp. 750 3. Income Summary 6,505 Capital 6,505 CRICOS Provider Code 00301J

  12. Post-closing Trial Balance • The accounting cycle ends with the post-closing trial balance. • The post-closing trial balance is dated as of the end of the period for which the statements have been prepared. • What accounts will a post-closing trial balance show? CRICOS Provider Code 00301J

  13. Accountants correct errors by making correcting journal entries Errors can arise at any stage of processing: Journal stage - it is necessary only to rewrite the entries to reflect the correction After posting to the general ledger - a correcting general journal entry is required . Objective 3: Correct Typical Accounting Errors CRICOS Provider Code 00301J

  14. Transaction was for $500 not $5,000 At journal stage – error detected prior to posting Cross out entry and initial Example 1 – Correct Accounting Error CRICOS Provider Code 00301J

  15. Transaction was for $500 not $5,000 Error detected after posting Correcting entry required Example 2 – Correct Accounting Error CRICOS Provider Code 00301J

  16. Are special types of entries that facilitate the accounting process for the new accounting period Relate to accrued revenue and expenses Reverses a previous adjusting entry Not required but they save accountants having to remember that part of a payment or receipt in the next period relates to the previous period. Objective 4: Reversing Entries CRICOS Provider Code 00301J

  17. Reversing Entry Example Assume wages of $15,000 have been paid during the period. An additional $10,000 needs to be accrued at the end of the period (30/6/07) i.e. earned but not paid 1. Adjusting Entry Cash Wages Expense Wages Payable 15,000 15,000 10,000 10,000 $25,000 $10,000 CRICOS Provider Code 00301J

  18. Reversing Entry Example 2. Closing Entry Cash Wages Expense Wages Payable 15,000 15,000 10,000 10,000 25,000 0 $10,000 CRICOS Provider Code 00301J

  19. Reversing Entry Example 3. Wages Paid Next Period (example 1 without reversing entry but correct allocation) Cash Wages Expense Wages Payable 15,000 10,000 14,000 4,000 10,000 4,000 CRICOS Provider Code 00301J

  20. Reversing Entry Example 3. Wages Paid Next Period (example 2 without reversing entry and incorrect allocation) Cash Wages Expense Wages Payable 15,000 10,000 14,000 14,000 $14,000 $10,000 CRICOS Provider Code 00301J

  21. Reversing Entry Example 3. Wages Paid Next Period (with reversing journal entry) Wages Payable 10,000 dr Wages Expense 10,000 cr Cash Wages Expense Wages Payable 15,000 10,000 10,000 10,000 14,000 14,000 $4,000 $0 CRICOS Provider Code 00301J

  22. Objective 5: Classify Assets & Liabilities • On the balance sheet, assets and liabilities are classified as either current or non-current to indicate their relative liquidity. • Current assets are cash or can be converted to cash within 1 year (or normal business cycle) • Non current assets are all other assets • Current liabilities are debts or obligations due within 1 year • Non current liabilities are all other liabilities CRICOS Provider Code 00301J

  23. Classify Assets & Liabilities • Balance Sheet Classification • Current assets are listed in order of decreasing liquidity • Current liabilities are listed in order of how soon they must be paid CRICOS Provider Code 00301J

  24. Different Formats of theBalance Sheet Report Format Account Format Assets = Liabilities + Owner’s Equity Assets = Liabilities + Owner’s Equity CRICOS Provider Code 00301J

  25. Objective 6: Use the current & debt ratio to evaluate a business • Current and Debt ratios are two common ratios that measure liquidity • Current Ratio measures the ability of a business to pay its current liabilities with its current assets • Current ratio = current assets/current liabilities • Debt Ratio indicates the proportion of a business’s assets that are financed with debt • Measures the ability to pay both short and long-term debt • Debt ratio = total liabilities/total assets CRICOS Provider Code 00301J

  26. Use the current & debt ratio to evaluate a business (examples) • Extract from Balance Sheet CRICOS Provider Code 00301J

  27. Use the current & debt ratio to evaluate a business • Current ratio – current assets/current liabilities • 20X4 6304/3932 = 1.6 • 20X5 6805/4261 = 1.6 • 20X6 7098/5348 = 1.3 • Debt ratio - total liabilities/total assets • 20X4 5151/8268 = .62 • 20X5 5252/8868 = .59 • 20X6 5968/9695 = .62 CRICOS Provider Code 00301J

  28. Objective 7(1): Profit Recognition • The profit recognition principle provides guidance on the timing and amount of profit to record - or more precisely revenue and expense recognition. • Profits should be recorded when earned and not before. • Interest and rent accrue with the passage of time. • Most sales and many services revenue is recognised at a point in time. CRICOS Provider Code 00301J

  29. Profit Recognition • In some businesses there are many phases in the earning of profits; • from customers ordering to the end of warranty period. • Three conditions for revenue to be recorded (AASB 118): • Control of the goods has passed to the purchaser • Collectibility of the revenue is probable • Amount can be easily measured CRICOS Provider Code 00301J

  30. Profit Recognition • Four Methods • Sales method; sales for cash and on credit. • Collection method; if receipt of cash is uncertain. • Instalment method; for instalment sales - provides same overall gross profit as the sales method - difference is the period/s in which it is recognised. • Percentage-of-completion method. CRICOS Provider Code 00301J

  31. Installment Method • Real estate developer sells land; • Down payment $200,000 (year 1) • Annual payments $250,000 (year 2) $260,000 (year 3) $290,000 (year 4) • If land cost $660,000 Gross Profit = $1,000,000 – 660,000 =$340,000 GP% = 340,000/1,000,000 = 34% CRICOS Provider Code 00301J

  32. Installment Method Year Collection x G.P.% = G.P. 1 $200,000 x 34% = $68,000 2 $250,000 x 34% = $85,000 3 $260,000 x 34% = $88,400 4 $290,000 x 34% = $98,600 Total $1,000,000 $340,000 CRICOS Provider Code 00301J

  33. Percentage-of-Completion Method • Especially for construction projects that extend over several periods. • Profit is recognised as the work is performed. • To use this method businesses need to be able to reliably estimate both • The outcome of the contract (profit) and percentage of project completed Steps: 1.Calculate % of project (divide costs incurred this period by total estimated project costs) 2. Multiply total project revenue by % of completion 3. Revenue less expenses = period profit CRICOS Provider Code 00301J

  34. Percentage of Completion Method Example: • Energy Corp is building a desalination plant • Total costs over 3 year project = $660,000 (y1=$100,000; y2=260,000; y3=300,000) • Clients are billed as follows: Y1 $330,000; Y2 $270,000; Y3 $400,000 (Total $1m) • Calculations • Costs: y1 = 100,000/660,000 = .15 y2 = 260,000/660,000 = .40 y3 = 300,000/660,000 = .45 • Revenue y1 = 1,000,000 * .15 = 150,000 y2 = 1,000,000 * .40 = 400,000 y3 = 1,000,000 * .45 = 450,000 • Profit y1 = 150,000 - 100,000 = $50,000 y2 = 400,000 - 260,000 = $140,000 y3 = 450,000 – 300,000 = $150,000 Total Profit = $340,000 (1,000,000 – 660,000) CRICOS Provider Code 00301J

  35. Instalment method vs. % of Completion Method Instalment % of Compl. `Year G.P. GP 1 $68,000 $ 50,000 2 $85,000 $140,000 3 $88,400 $150,000 4 $98,600 Total $340,000 $340,000 Instalment – based on collections * GP% % of Completion – based on expected revenues * yearly costs/total costs CRICOS Provider Code 00301J

  36. Percentage-of-Completion Method • Where estimates are not possible AASB 111 Construction Contracts requires; • costs incurred to be recognised as an expense • Where it is probable cost will be covered by revenue • revenue equal to costs is recognised and nil profits reported • all profits are reported upon completion. • If a loss is likely on the contract the full amount of the expected loss should be taken up immediately - even if the construction has not commenced. • An example of conservatism - do not anticipate any profits but anticipate all losses. CRICOS Provider Code 00301J

  37. Objective 7(2): Measurement Issues • Transactions are recorded at historical cost - what was paid for assets or expenses. • The information is: • reliable • relatively easy to identify • objective • usually recorded for commercial reasons. CRICOS Provider Code 00301J

  38. Measurement Issues • Historical cost not always used • AASB 102 allows the ‘write down’ of inventory if their net realisable value falls below purchase price. • AASB 116 allows assets to be revalued to market value (up or down) CRICOS Provider Code 00301J

  39. Measurement Issues • Market Value • Less reliable than historic cost but may be more relevant. • Could increase profits and increase assets, (but only if the asset was sold). • Could increase assets and increase owners’ equity • Could disclose market values in the notes and not alter the figures in the balance sheet. CRICOS Provider Code 00301J

  40. Objective 7(3): Disclosure Policies • AASB 101 Presentation of Financial Statements, requires a summary of accounting policies be given in the initial section of the notes. • The specific accounting principles, bases or rules adopted. • Describe the measurement basic e.g. H.C. • Give the method of accounting when there is choice e.g. method of depreciation. CRICOS Provider Code 00301J

  41. Disclosure Policies • AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors • Consistency is important for comparability. • If a change is made the company should reveal: • nature of the change • reason for the change • effect of the change on net profits. • Change in accounting policy • Eg. FIFO to LIFO • Change in accounting estimate • Eg. life of an asset is extended CRICOS Provider Code 00301J

  42. Disclosure Policies • AASB 110 Events After the Balance Sheet Date • There is a period of time between the reporting date (end of the financial year) and the publishing of the financial statements (authorised for issue). • 2 Types of Events: • Those that provide evidence of conditions that existed at the reporting date – requires adjustment • Those that are indicative of conditions that arose after the reporting date – no adjustment but requires disclosure if material CRICOS Provider Code 00301J

  43. Disclosure Policies • AASB 110 Events After the Balance Sheet Date • Adjusting Events • Settlement of court case • Asset impairment • Existing customer declared bankrupt • Non-adjusting Events • Decline in market value of investments • Dividend declaration • Non-adjusting Events that are material and require disclosure • The nature of the event • An estimate of the financial effect or statement that it cannot be estimated. • Change in business combination • Discontinuance of an operation • Major purchases of assets; change in classification of assets (for use or for sale) • Destruction of a major plant/operation CRICOS Provider Code 00301J

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