1 THE ACCOUNTING CYCLE 1. Entries are recorded at the time transactions occur. Format: Dr Cr. Some examples: 1. An attorney invested $50,000 to open a law office. 2. $40,000 was borrowed from a bank and a note payable was signed. 3. Supplies costing $3,000 were purchased on account. 4. Services were performed on account for $10,000. 5. Salaries of $5,000 were paid to employees. 6. $500 of supplies were used. 2 2. Adjusting Entries Are made at the end of the accounting period (month, quarter or year). They are made in order to record economic events related to a company’s earnings activities that have occurred but have not been recorded at the end of the accounting period or to adjust the balances of accrued liabilities and prepaid assets. Effects: each adjusting entry affects both a balance sheet account and an income statement account Caution: the form of the adjusting entry depends on how the transaction was initially recorded. Adjusting Entries for Prepayments Note: Prepayments occur when the cash flow precedes either expense or revenue recognition. Example: Two companies each paid $1200 on June 30 for an insurance policy that provides coverage for two years. Each company yearend is December 31. A. Company A expensed the $1200 at June 30. What is the adjusting entry? B. Co. B recorded the expenditure as prepaid insurance on June 30. Adjusting entry: What is the adjusting entry? What is the balance in prepaid insurance and insurance expense (after adjustment) for each company? 3 Another example of prepayments: A health club collects cash upfront from its members who then can use the facility. During 2005, it collected $520,000 of which $220,000 is still unearned. If the company made the following entry as cash was collected: Dr. Cash Cr. Unearned Revenue What is the adjusting entry? But if the company recorded the cash collections as follows: Dr. Cash Cr. Revenue What is the adjusting entry? What will be the balance in unearned revenue and revenue for each case? 4 Adjusting Entries for Accruals: Accruals involve transactions where the cash outflow or inflow occurs in a period subsequent to expense or revenue recognition. Expenses incurred but not yet paid including salaries, wages, commissions, utilities, bonuses, rent, interest, etc. OR Revenues earned but you have not yet received the assets (such as cash) including interest (if you are the creditor), rent, etc. Adjusting Entries for Estimates: 3. Trial Balance List of open accounts in the general ledger Proves that debits = credits Can be either adjusted or unadjusted or post-closing 4. Closing Entries Close out revenue and expense accounts to income summary and income summary into retained earnings. 5. Preparation of financial statements and disclosures What are the financial statements?