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 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, 12/31/05 1,760 Sales revenue 35,000 Cost of goods sold 27,500 Operating expenses 6,300 Totals $ 57,385 $ 57,385 Problem Following unadjusted account balances for Delilah’s Deluxe Doggie Dayspa: Delilah's Deluxe Doggie Dayspa Unadjusted Trial Balance December 31, 2005 Cash 13,500 Accounts Receivable 14,000 Supplies 3,500 Prepaid Rent 24,000 Prepaid Insurance 12,000 Notes Receivable (due 3/31/04) 30,000 Equipment 245,000 Accounts Payable 12,500 Unearned Service Revenue 20,000 Notes Payable (due 5/1/07) 100,000 Common Stock 50,000 Dividends 12,000 Service Revenue 367,500 Salary Expense 165,000 Rent Expense 20,000 Income Tax Expense 11,000 Required: Prepare a trial balance in good form. 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 There are two types of adjusting entries. ACCRUALS DEFERRALS Revenues Receipts of earned or assets or expenses payments of incurred that cash in advance have not been of revenue or previously expense recorded. 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 This is a “cost depreciation involves allocation” concept, the systematic and not a “valuation” rational allocation of concept. the cost of a long- lived asset over multiple accounting periods it is used to generate revenue. Prepare the Adjusted Trial Balance • After we’ve 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) Delilah’s has a 6 day work week, Monday through Saturday. (accrued expense/ liability) Employees are paid every Friday. 12/31 is on a Tuesday. Delilah’s 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 Delilah’s, 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 balance sheet 1. Transfer net income account balances (or loss) to Retained carry forward Earnings. from period to 2. Establish a zero period, the balance in each of the income statement temporary accounts to accounts do not. start the next 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 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, 12/31/04 2,960 Sales revenue - Cost of goods sold - Operating expenses - Totals $ 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 Net Income = Margin Net Sales Problem Prepare closing entries and post-closing trial balance for Delilah’s. Prepare net profit margin for Delilah’s.