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Chapter 4

Chapter 4. Completing the Accounting Cycle. Objectives of the Chapter. Discuss the steps in the accounting cycle. Introduce the worksheet paper to facilitate the preparation of financial statements. Explain the process of closing the books.

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Chapter 4

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  1. Chapter 4 Completing the Accounting Cycle

  2. Objectives of the Chapter • Discuss the steps in the accounting cycle. • Introduce the worksheet paper to facilitate the preparation of financial statements. • Explain the process of closing the books. • Discuss the content of a post-closing trial balance. • Explain the correcting entries. • Discuss the sections of a classified balance sheet. • Accounting ratios for decision making. Accrual Accounting and the Financial Statements

  3. The Accounting Process 1. Identification and measurement of business transactions; 2. Journalization (recordbusiness transactions using the double-entry system); 3. Post (post journal entries to ledger accounts); 4. Prepare worksheet (including unadjusted trial balance, adjustments; adjusted trial balance, etc.) 5. Prepare financial statements based on the adjusted trial balance; Accounting Cycle

  4. Accounting Process (contd.) 6. Prepare and post adjusting entries; 7. Prepare and post closing entries; 8. Prepare post-closing trial balance (optional). Note: Steps 1,2 ,3 and the unadjusted trial balance are discussed in chapter 2. The adjustments (i.e., adjusting entries) are discussed in chapter 3. Accounting Cycle

  5. Using A Worksheet (Source: KWW PowerPoint Presentations) • A multiple-column form used in preparing financial statements. • Not a permanent accounting record. • Use of worksheet is optional. SO 1 Prepare a worksheet.

  6. Steps in Preparing a Worksheet (Source: KWW PowerPoint Presentations) Illustration 4-1 SO 1 Prepare a worksheet.

  7. A Worksheet Paper with Unadjusted Trial Balance (Source: Financial Accounting by Harrison and Horngren) AIR & SEA TRAVEL, INC.Unadjusted Trial Balance April 30, 19X1 Accrual Accounting and the Financial Statements 7

  8. Information for Adjustments at 4/30/ 19x1 (from Financial Accounting by Harrison and Horngren and used in chapter 3 notes): (a) Prepaid rent expired, $1,000. (b) Supplies on hand, $400 (balance before adjustment equals $700). (c) Depreciation on furniture, $275. (d) Accrued salary expense, $950. (e) Accrued service revenue, $250. (f) Amount of unearned service revenue that has been earned, $150. (g) Accrued income tax expense, $540. Accrual Accounting and the Financial Statements 8

  9. Worksheet Paper with Adjusted Trial Balance AIR & SEA TRAVEL, INC.Preparation of Adjusted Trial Balance April 30, 19X1 (from Harrison and Horngren) Accrual Accounting and the Financial Statements 9

  10. Balance Sheet (Exhibit 4-3) Statement of Retained Earnings (Exhibit 4-2) Income Statement (Exhibit 4-1) Preparing the Financial Statements of Air & Sea Travel, Inc., from the Adjusted Trial Balance(from Harrison and Horngren Accrual Accounting and the Financial Statements 10

  11. Exhibit 4-1 Income Statement (from Harrison and Horngren) AIR & SEA TRAVEL, INC.Income StatementFor the Month Ended April 30, 19X1 Revenue: Service revenue…………... $7,400 Expenses: Salary expense…………… $1,900 Rent expense……………… 1,000 Utilities expense………….. 400 Supplies expense…………. 300 Depreciation expense…….. 275 3,875 Income before tax………….. 3,525 Income tax expense………… 540 Net income…………………. $2,985  Accrual Accounting and the Financial Statements 11

  12. Exhibit 4-2 Statement of Earnings(from Harrison and Horngren) Retained earnings, April 1, 19X1…… $11,250 Add: Net income……………………… $2,985 14,235 Less: Dividends……………………… 3,200 Retained earnings, April 30, 19X1….. $11,035 AIR & SEA TRAVEL, INC.Statement of Retained EarningsFor the Month Ended April 30, 19X1   Accrual Accounting and the Financial Statements 12

  13. Exhibit 4-3 Balance Sheet (from Harrison and Horngren AIR & SEA TRAVEL, INC.Balance SheetApril 30, 19X1  Assets Cash……………….….. $24,800 Account receivable...…. 25,00 Supplies………………. 400 Prepaid rent…………... 2,000 Furniture…….. $16,500 Less Accumulated depreciation….. 275 16,225 . Total assets………….. $45,925 Liabilities Accounts payable…………. $13,100 Salary payable…………….. 950 Unearned service revenue.... 300 Income tax payable….……. 540 Total liabilities……………. 14,890 Stockholders’ Equity Common stock……………. 20,000 Retained earnings…………. 11,035 Total stockholders’ equity… 31,035 Total liabilities and . stockholders’ equity……. $45,925 Accrual Accounting and the Financial Statements 13

  14. Preparing the Adjusting Entries (a) Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense. (b) Supplies Expense 300 Supplies 300 To record supplies used. (c) Depreciation Exp. - Furniture 275 Accumulated Depr. - Furniture 275 To record depreciation on furniture. (d) Salary Expense 950 Salary Payable 950 To accrue salary expense. Accrual Accounting and the Financial Statements 14

  15. Adjusting Entries(contd.) (e) Accounts Receivable 250 Service Revenue 250 To accrue service revenue. (f) Unearned Service Revenue 150 Service Revenue 150 To record unearned revenue that has been earned. (g) Income Tax Expense 540 Income Tax Payable 540 To accrue income tax expense. Accrual Accounting and the Financial Statements 15

  16. Ledger Accounts with Adjusted Entries Posted ASSETS LIABILITIES STOCKHOLDERS’ EQUITY A/P Bal. 13,100 EXPENSES Rent Exp. (a) 1,000 Bal. 1,000 Comm Stock Bal. 20,000 Cash Bal. 24,800 A/R 2,250 (e) 250 Bal. 2,500 Retained Earnings Bal. 11,250 Salary Payable (d) 950 Bal. 950 Salary Exp. 950 (d) 950 Bal. 1,900 Supplies 700 (b) 300 Bal. 400 Dividends Bal.3,200 Unearned Service Rev. (f) 150 450 Bal. 300 Supplies Exp. (b) 300 Bal. 300 Prepaid Rent 3,000 (a) 1,000 Bal. 2,000 Depr. Exp.-Furniture (c) 275 Bal. 275 I/T Payable (g) 540 Bal. 540 Furniture Bal. 16,500 REVENUE Service Rev. 7,000 (e) 250 (f) 150 Bal. 7,400 Utilities Exp. Bal. 400 Accumulated Depr.--Furniture (c) 275 Bal. 275 I/T Exp. (g) 540 Bal. 540 Accrual Accounting and the Financial Statements 16

  17. Closing Entries • All temporary accounts (i.e., revenues, expenses, gains and losses accounts) are closed to an income summary account. • The income summary account is closed to the retained earnings account. • Purpose: all temporary accounts would have a zero beginning balance in a subsequent period after being closed at the end of a previous period. Accrual Accounting and the Financial Statements

  18. Closing the Books (source: KWW PowerPoint presentations) At the end of the accounting period, the company makes the accounts ready for the next period. Illustration 4-5 SO 2 Explain the process of closing the books.

  19. Closing Entries for Air and Sea Travel, Inc. on 4/30 4/30 Service Revenue 7,400 Income Summary 7,400 4/30 Income Summary 4,415 Rent Exp. 1,000 Salary Exp. 1,900 Supplies Exp 300 Depre. Exp. 275 Utilities Exp. 400 Income Tax Exp. 540 4/30 Income Summary ($7,400-$4,415) 2,985 Retained Earnings 2,985 4/30 Retained Earnings 3,200 Dividends 3,200 Accrual Accounting and the Financial Statements 19

  20. Posting Closing Entries to the Ledger Accounts Accrual Accounting and the Financial Statements 20

  21. Post-Closing Trial Balance (from Harrison and Horngren AIR & SEA TRAVEL, INC.Post-closing Trial BalanceApril 30, 19X1 Cash………………………………. $24,800 Accounts receivable…………….. 2,500 Supplies…………………………… 400 Prepaid rent……………………….. 2,000 Furniture…………………………... 16,500 Accumulated depreciation………. $ 275 Accounts payable…………………. 13,100 Salary payable…………………….. 950 Unearned service revenue………. 300 Income tax payable……………….. 540 Common stock…………………….. 20,000 Retained earnings………………… 11,035 Total……………………………….. $46,200 $46,200 Accrual Accounting and the Financial Statements 21

  22. Correcting Accounting Errors • When an error is detected after posting, the accountant makes a correcting entry. • Example: $5,000 cash was paid for furniture but was erroneously debited supplies as follows: Supplies 5,000 Cash 5,000 Correcting Entry Furniture 5,000 Supplies 5,000 Accrual Accounting and the Financial Statements

  23. Classified Balance Sheet Statement • Accounts with similar characteristics are grouped together on the balance sheet. • Categories of accounts: 1. Assets 2. Liabilities 3. Stockholders’ equity Accrual Accounting and the Financial Statements

  24. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) • Presents a snapshot at a point in time. • To improve understanding, companies group similar assets and similar liabilities together. Standard Classifications Illustration 4-17 Assets Liabilities and Owner’s Equity Current assets Current liabilities Long-term investments Long-term liabilities Property, plant, and equipment Stockholders’ equity Intangible assets SO 6 Identify the sections of a classified balance sheet.

  25. Assets • Assets: Resources with future economic benefit to a business entity as a result of a past transaction • a. Current assets: Cash and other assets that are reasonably expected to be realized in cash or sold, or consumed during the normal operating cycle or one year, whichever is longer. Accrual Accounting and the Financial Statements

  26. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Current Assets Illustration 4-19 • Companies usually list current asset accounts in the order they expect to convert them into cash. SO 6 Identify the sections of a classified balance sheet.

  27. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Long-Term Investments b.Investments in buildings or land not used in current operations; investments in bonds or stocks of other companies . Illustration 4-20 SO 6 Identify the sections of a classified balance sheet.

  28. Assets (contd.) c. Property, plant, and equipment: assets used in firms' operations and meet the following criteria: • Economic life > 1 year. • Acquired for use in operation. • Not for resale to customers. • $ is material. Depreciation is applied. Accrual Accounting and the Financial Statements

  29. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Property, Plant, and Equipment Illustration 4-21 SO 6 Identify the sections of a classified balance sheet.

  30. Assets (contd.) d. Intangible assets: Assets with no physical substance but have value based on rights or privileges that belong to the owner (i.e., patents, franchises, trademarks,…) e. Other assets: Deferred charges (long-term prepayments) Accrual Accounting and the Financial Statements

  31. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Intangible Assets • Assets that do not have physical substance. Illustration 4-22 SO 6 Identify the sections of a classified balance sheet.

  32. Liabilities • Legal obligations required future payments of assets or services as a result of a business entity’s past transactions or events. a. Current liabilities: Obligations must be fulfilled in one year or one operating cycle, whichever is longer. Will require the use of current assets or the creation of current liability. Accrual Accounting and the Financial Statements

  33. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Current Liabilities Illustration 4-23 SO 6 Identify the sections of a classified balance sheet.

  34. Liabilities (contd.) b. Long-term liabilities: Obligations are not due in next year or next operating cycle, whichever is longer. c. Other liabilities: Long-term advances from customers, deferred income taxes. Accrual Accounting and the Financial Statements

  35. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Long-Term Liabilities • Obligations a company expects to pay after one year. Illustration 4-24 SO 6 Identify the sections of a classified balance sheet.

  36. Stockholders’ Equity • Residual claims (Assets-Liabilities) to the business entity from stockholders. a. Contributed capital (Legal capital): includes Par value of common stock, par value of prefer stock and paid-in capital in excess of par value of common stock or preferred stock. b. Retained Earnings (or deficit): income not distributed to stockholders Accrual Accounting and the Financial Statements

  37. The Classified Balance Sheet (Source: KWW PowerPoint Presentations) Stockholders’ (Owner’s) Equity • Proprietorship - one capital account. • Partnership - capital account for each partner. • Corporation - Capital Stock and Retained Earnings. Illustration 4-25 SO 6 Identify the sections of a classified balance sheet.

  38. (In thousands) 1995 1994 Classified Balance Sheet of Hawaiian Airlines, Inc. (Source: Harrison and Horngren) HAWAIIAN AIRLINES, INC.Classified Balance Sheet (Adapted)December 31, 1995 and 1994 ASSETS Current Assets: 1. Cash and cash equivalents…………….. $ 5,389 $ 3,501 2. Accounts receivable………………….... 18,178 16,275 3. Inventories…………………………….. 7,648 6,234 4. Assets held for sale……………………. 1,344 1,594 5. Prepaid expenses………………………. 5,804 6,079 6. Total current assets………………... 38,363 33,683 PROPERTY AND EQUIPMENT 7. Flight equipment……………………….. 40,659 34,702 8. Ground equipment, buildings, and leasehold improvements…………….. 5,775 3,976 9. Accumulated depr. and amortization…... (5,043) (922) 10. Property and equipment, net…………. 41,391 37,756 11. Other Assets…………………………… 81,886 91,862 12. Total Assets…………………………. $ 161,640$ 163,301 Accrual Accounting and the Financial Statements 38

  39. (In thousands) 1995 1994 Exhibit 3-17 (Continued) LIABILITIES AND SHAREHOLDERS’ EQUITY Current Liabilities: 13. Current portion of long-term debt………………….. $ 6,027 $ 6,394 14. Current portion of capital lease obligations………... 2,662 2,907 15. Accounts payable…………………………………... 35,182 17,529 16. Air traffic liability…………………………………... 30,461 40,382 17. Other accrued liabilities…………………………….. 15,730 12,298 18. Total current liabilities…………………………. 90,062 79,510 19. Long-Term Debt…………………………………... 5,523 14,152 20. Capital Lease Obligations………………………… 10,102 12,764 21. Other Liabilities…………………………………… 26,775 23,026 Shareholders’ Equity 22. Common stock……………………………………… 41,287 40,000 23. Other………………………………………………... (452) ---- 24. Accumulated deficit………………………………… (11,657) (6,151) 25. Shareholders’ equity……………………………. 29,178 33,849 26. Total Liabilities and Shareholders’ Equity...$161,640 $163,301 Accrual Accounting and the Financial Statements 39

  40. 6. Different Formats for the Balance Sheet B/S B/S Assets Liabilities Assets Equity Liabilities and Equity Accrual Accounting and the Financial Statements

  41. Using Accounting Information in Decision making: Accounting Ratios A. Current Ratio B. Debt Ratio Accrual Accounting and the Financial Statements

  42. A. Current Ratio Current Ratio = Current Assets Current Liabilities 1. This ratio measures the company’s ability to pay current liabilities with current assets. 2. Users of this ratios: creditor, stockholders, and managers (who must maintain enough cash to pay the company’s current liabilities). Accrual Accounting and the Financial Statements

  43. A. Current Ratio (contd.) 3. What is a good value of this ratio: depends on the industry and the cash flows of a company. A company with a strong cash flow can operate at a lower current ratio than a company with weak cash flow. 4. What happens when the ratio is low? 5. Can the current ratio be too high? Accrual Accounting and the Financial Statements

  44. B. Debt Ratio Debt Ratio = Total Liabilities Total Assets 1. This ratio measures the ability of a company to pay its total liabilities. 2. Users of this ratio: creditors, stockholders and manager. Accrual Accounting and the Financial Statements

  45. B. Debt Ratio (contd.) 3. What is a good value of this ratio: depends on the industry and the cash flows of a company. A company with a strong cash flow can operate with a high debt ratio at than otherwise. 4. What happens when the debt ratio is high? 5. Can the ratio be too low? Accrual Accounting and the Financial Statements

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