Accounting Process & Concepts Business Transactions & Completing Accounting Cycle By: Associate Professor Dr. GholamReza Zandi

The Role of Accounting Records Establishes accountability for assets and transactions. Keeps track of routine business activities. Obtains detailed information about a particular transaction. Evaluates efficiency and performance within company. Maintains evidence of a company’s business activities.

The Ledger The entire group of accounts is kept together in an accounting record called a ledger. Cash Accounts Payable Capital Stock Accounts are individual records showing increases and decreases.

The Use of Accounts Increases are recorded on one side of the T account, and decreases are recorded on the other side. Left or Debit Side Right or Credit Side Title of Account

Receipts are on the debit side. Payments are on the credit side. The balance is the difference between the debit and credit entries in the account. Debit and Credit Entries

ALOE A = L + OEASSETS Debit for Increase Credit for DecreaseEQUITIES Debit for Decrease Credit for IncreaseLIABILITIES Debit for Decrease Credit for Increase Debits and credits affect accounts as follows: Debit and Credit Entries

ALOE A = L + OE Debit balances Credit balances = In the double-entry accounting system, every transaction is recorded by equal dollar amounts of debits and credits. Double Entry Accounting  The Equality of Debits and Credits

Let’s record selected transactions for Overnight Auto Service in the accounts.

3-9  January 20: Michael McBryan and his family invested $80,000 in Overnight Auto Service and received 8,000 shares of stock at $10 per share. Cash increases $80,000 with a debit. Capital Stock increases $80,000 with a credit.

3-10  Jan. 21: Overnight purchased land for $52,000 cash. Cash decreases $52,000 with a credit. Land increases $52,000 with a debit.

3-11  Jan. 22: Overnight purchased a garage for $36,000 by paying $6,000 in cash and issuing a note payable for the remaining $30,000. Building increases $36,000 with a debit. Cash decreases $6,000 with a credit. Notes Payable increases $30,000 with a credit.

3-12  Jan 23: Overnight Auto Service purchased tools and equipment for $13,800 on account. Tools & Equipment increases $13,800 with a debit. Accounts Payable increases $13,800 with a credit.

3-13 Tools & Equipment decreases $1,800 with a credit. Accounts Receivable increases $1,800 with a debit.  Jan 24: Overnight sold part of the tools and equipment to Ace Towing for $1,800, a price equal to Overnight’s cost. Ace agrees to pay Overnight on account in the future.

In an actual accounting system, transactions are initially recorded in the journal. The Journal

Posting Journal Entries to the Ledger Accounts Posting simply means updating the ledger accounts for the effects of the transactions recorded in the journal.

Posting Journal Entries to the Ledger Accounts

Let’s see what the cash account looks like after posting the cash portion of this transaction for Overnight Auto Service. Posting Journal Entries to the Ledger Accounts

This ledger format is referred to as a running balance. Ledger Accounts After Posting

T accounts are simplified versions of the ledger account that only show the debit and credit columns. Ledger Accounts After Posting

Net income is not an asset  it’s an increase in owners’ equity from profits of the business. ALOE A = L + OE IncreaseDecrease As income is earned, either an asset is increased or a liability is decreased. Increase Net income always results in the increase of Owners’ Equity What is Net Income?

ALOE A = L + OE Retained Earnings Capital Stock Retained Earnings The balance in the Retained Earnings account represents the total net income of the corporation over the entire lifetime of the business, less all amounts which have been distributed to the stockholders as dividends.

The income statement summarizes the profitability of a business for a specified period of time. The Income Statement: A Preview

Accounting Periods Time Period Principle To provide users of financial statements with timely information, net income is measured for relatively short accounting periods of equal length. Time Period Principle To provide users of financial statements with timely information, net income is measured for relatively short accounting periods of equal length.

Revenue and Expenses The price for goods sold and services rendered during a given accounting period. Increases owners’ equity. The costs of goods and services used up in the process of earning revenue. Decreases owner’s equity.

The Matching Principle: When To Record Revenue Matching Principle Revenue should be recognized at the time goods are sold and services are rendered.

The Matching Principle: When To Record Expenses Matching Principle Expenses should be recorded in the period in which they are used up.

The Accrual Basis of Accounting Current Accounting Period Future Accounting Period Jan. 1, 2015 Dec. 1, 2015 Jan. 1, 2016 Dec. 1, 2016 Cash is received or paid here The income statement reports revenue or expense here The income statement reports revenue or expenses here Cash is received or paid here OR But...

Debit and Credit Rules for Revenue and Expenses EQUITIES Debit for Decrease Credit for Increase Expenses decrease owners’ equity. Revenues increase owners’ equity. EXPENSES Credit for Decrease Debit for Increase REVENUES Debit for Decrease Credit for Increase

EQUITIES Debit for Decrease Credit for Increase Payments to owners decrease owners’ equity. Owners’ investments increase owners’ equity. DIVIDENDS Credit for Decrease Debit for Increase Dividends CAPITAL STOCK Debit for Decrease Credit for Increase

Let’s analyze the revenue and expense transactions for Overnight Auto Service for the month of February. We will also analyze a dividend transaction. Let’s analyze the revenue and expense transactions for Overnight Auto Service for the month of February. We will also analyze a dividend transaction.

3-32 FEB. 1: Paid Daily Tribune $360 cash for newspaper advertising to be run during February. Cash decreases $360 with a credit. Advertising Expense increases $360 with a debit.

3-33 FEB. 2: Purchased radio advertising from KRAM to be aired in February. The cost was $470, payable within 30 days. Accounts payable increases $470 with a credit. Advertising Expense increases $470 with a debit.

3-34 Accounts payable increases $1,400 with a credit. Shop Supplies increases $1,400 with a debit. FEB. 4: Purchased various supplies for $1,400, payable within 30 days. The supplies are expected to be used over the next 3 to 4 months.

3-35 Cash increases $4,980 with a debit. Repair Service Revenue increases $4,980 with a credit. FEB 15: Overnight collected $4,980 cash for repairs made to vehicles of Airport Shuttle Service.

3-36 Accounts receivable increases $5,400 with a debit. Repair Service Revenue increases $5,400 with a credit. FEB 28: Overnight billed Harbor Cab Co. $5,400 for maintenance and repair services provided in February, with payment to be received by March 10.

3-37 FEB 28: Overnight paid employee’s wages earned in February, $4,900. Cash decreases $4,900 with a credit. Wages Expense increases $4,900 with a debit.

3-38 FEB 28: Overnight recorded a $1,600 utility bill for February. The entire amount is due March 15. Accounts Payable increases $1,600 with a credit. Utilities Expense increases $1,600 with a debit.

3-39 Cash decreases $3,200 with a credit. Dividends increase $3,200 with a debit. FEB 28: Overnight Auto Services declares and pays a dividend of 40 cents per share to the owners of its 8,000 shares of capital stock—a total of $3,200.

Now, let’s look at the Trial Balance for Overnight Auto Service for the month of February.

All balances are taken from the ledger accounts on Feb 28 after considering all of Overnight’s transactions for the month.

The Accounting Cycle in Perspective Accountants spend much of their time focusing on the more analytical aspects of their discipline.

Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. Adjusting Entries

 Converting assets to expenses  Accruing unpaid expenses  Converting liabilities to revenue  Accruing uncollected revenue Types of Adjusting Entries

Prior PeriodsCurrent PeriodFuture Periods Transaction Paid cash in advance of incurring expense (creates an asset). Transaction Paid cash in advance of incurring expense (creates an asset). End of Current Period Adjusting Entry  Recognizes portion of asset consumed as expense, and  Reduces balance of asset account. Adjusting Entry  Recognizes portion of asset consumed as expense, and  Reduces balance of asset account. Converting Assets to Expenses

Mar. 1Feb.28 $18,000 Insurance Policy Coverage for 12 Months $1,500 Monthly Insurance Expense On March 1, Overnight Auto Services purchased a one-year insurance policy for $18,000. Converting Assets to Expenses

Initially, costs that benefit more than one accounting period are recorded as assets. Converting Assets to Expenses

The costs are expensed as they are used to generate revenue. Converting Assets to Expenses

Income Statement Cost of assets used this period to generate revenue. Income Statement Cost of assets used this period to generate revenue. Balance Sheet Cost of assets that benefit future periods. Balance Sheet Cost of assets that benefit future periods. Converting Assets to Expenses

The Concept of Depreciation Depreciation is the systematic allocation of the cost of a depreciable asset to expense. Cash (credit) Fixed Asset (debit) On date when initial payment is made... The asset’s usefulness is partially consumed during the period. At end of period... Depreciation Expense (debit) Accumulated Depreciation (credit)

On Jan. 22, 2015, Overnight Auto Service purchased a building with a useful life of 240 months for $36,000. Using the straight-line method, calculate the monthly depreciation expense. $36, = $150/month Depreciation expense (per period) = Cost of the asset Estimated useful life Depreciation Is Only an Estimate

Overnight Auto Service would make the following adjusting entry. Contra-asset Depreciation Is Only an Estimate

Overnight depreciates its $12,000 of tools and equipment over 60 months. Calculate monthly depreciation and make the journal entry. $12,000  60 months = $200 per month Depreciation Is Only an Estimate

We will assume that Overnight did not record any depreciation expense in January because it operated for only a small part of the month. Depreciation Is Only an Estimate Cost - Accumulated Depreciation = Book Value December 31, 2015 Balance Sheet Presentation

Prior PeriodsCurrent PeriodFuture Periods Transaction Collect cash in advance of earning revenue (creates a liability). Transaction Collect cash in advance of earning revenue (creates a liability). End of Current Period Adjusting Entry  Recognizes portion earned as revenue, and  Reduces balance of liability account. Adjusting Entry  Recognizes portion earned as revenue, and  Reduces balance of liability account. Converting Liabilities to Revenue

Dec. 1Feb. 28 $3,000 Rental Contract Coverage for 3 Months $1,000 Monthly Rental Revenue On December 1, Overnight received $3,000 in advance for a three-month rental contract. Converting Liabilities to Revenue

Initially, revenues that benefit more than one accounting period are recorded as liabilities. Converting Liabilities to Revenue

Over time, the revenue is recognized as it is earned. Converting Liabilities to Revenue

Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Liability for future periods. Balance Sheet Liability for future periods. Converting Liabilities to Revenue

Prior PeriodsCurrent PeriodFuture Periods Transaction Pay cash in settlement of liability. Transaction Pay cash in settlement of liability. End of Current Period Adjusting Entry  Recognizes expense incurred, and  Records liability for future payment. Adjusting Entry  Recognizes expense incurred, and  Records liability for future payment. Accruing Unpaid Expenses

Monday, Dec. 30 Friday, Jan. 3 $1,950 Wages Expense On Dec. 31, Overnight owes wages of $1,950. Payday is Friday, Jan. 3. Tuesday, Dec. 31 Accruing Unpaid Expenses

Initially, an expense and a liability are recorded. Accruing Unpaid Expenses

Income Statement Cost incurred this period to generate revenue. Income Statement Cost incurred this period to generate revenue. Balance Sheet Liability to be paid in a future period. Balance Sheet Liability to be paid in a future period. Accruing Unpaid Expenses

Monday, Dec. 30 Friday, Jan. 3 $2,397 Weekly Wages Let’s look at the entry for Jan. 3. Tuesday, Dec. 31 $447 Wages Expense $1,950 Wages Expense Accruing Unpaid Expenses

The liability is extinguished when the debt is paid. Accruing Unpaid Expenses

Prior PeriodsCurrent PeriodFuture Periods Transaction Collect cash in settlement of receivable. Transaction Collect cash in settlement of receivable. End of Current Period Adjusting Entry  Recognizes revenue earned but not yet recorded, and  Records receivable. Adjusting Entry  Recognizes revenue earned but not yet recorded, and  Records receivable. Accruing Uncollected Revenue

Dec. 15Jan. 15 $750 Repair Service Revenue On Dec. 31, Airport Shuttle owes Overnight half of it maintenance agreement. The one- month fee of $1,500 is to be paid is to be paid on the 15 th day of January. Dec. 31 Accruing Uncollected Revenue

Initially, the revenue is recognized and a receivable is created. Accruing Uncollected Revenue

Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Receivable to be collected in a future period. Balance Sheet Receivable to be collected in a future period. Accruing Uncollected Revenue

Dec. 15Jan. 15 $1,500 Monthly Interest $750 Service Revenue Let’s look at the entry for January 15. Dec. 31 $750 Service Revenue Accruing Uncollected Revenue

The receivable is collected in a future period. Accruing Uncollected Revenue

As a corporation earns taxable income, it incurs income taxes expense, and also a liability to governmental tax authorities. Accruing Income Taxes Expense: The Final Adjusting Entry

Costs are matched with revenue in two ways:  Direct association of costs with specific revenue transactions.  Systematic allocation of costs over the “useful life” of the expenditure. Adjusting Entries and Accounting Principles

An item is “material” if knowledge of the item might reasonably influence the decisions of users of financial statements. Supplies Light bulbs Many companies immediately charge the cost of immaterial items to expense. The Concept of Materiality

Effects of the Adjusting Entries

After these adjustments are posted to the ledger, Overnight’s ledger accounts will be up-to- date (except for the balance in the Retained Earnings account).

Financial Statements Publicly owned companies – those with shares listed on a stock exchange – have obligations to release annual and quarterly information to their stockholders and to the public. The annual report includes comparative financial statements and other information relating to the company’s financial position, business operations, and future prospects. The financial statements contained in the annual report must be audited by a firm of certified public accountants (CPAs).

The financial statements for Overnight Auto Service for 2015.

Net income also appears on the Statement of Retained Earnings. The Income Statement

The Statement of Retained Earnings

The Balance Sheet

Relationships among the Financial Statements

Notes to the Financial Statements Examples of Items Disclosed  Lawsuits pending  Scheduled plant closings  Governmental investigations  Significant events occurring after the balance sheet date  Specific customers that account for a large portion of revenue  Unusual transactions and related party transactions Examples of Items Disclosed  Lawsuits pending  Scheduled plant closings  Governmental investigations  Significant events occurring after the balance sheet date  Specific customers that account for a large portion of revenue  Unusual transactions and related party transactions Drafting the Notes that Accompany Financial Statements

Closing the Temporary Accounts  Close Revenue accounts to Income Summary.  Close Expense accounts to Income Summary.  Close Income Summary account to Retained Earnings.  Close Dividends to Retained Earnings. The closing process gets the temporary accounts ready for the next accounting period.

Closing the Temporary Accounts

Since both revenue accounts have credit balances, the closing entry requires a debit to the Revenue accounts. Closing Entries for Revenue Accounts

Closing Entries for Expense Accounts Net Income

Since Income Summary has a $39,942 credit balance, the closing entry requires a debit to Income Summary. Closing the Income Summary Account

The balance in Income Summary is now zero. Closing the Income Summary Account

Since the Dividends account has a debit balance, the closing entry requires a credit to the Dividends account. Closing the Dividends Account

After-Closing Trial Balance

Evaluating Profitability Evaluating Liquidity Evaluating the Business Net Income Percentage Net Income Total Revenue = Return on Equity Net Income Avg. Stockholders’ Equity = Current Ratio Current Assets Current Liabilities = Working Capital Current Assets – Current Liabilities =

Monthly Quarterly Jan. 1 Dec. 31 Annually Many companies prepare financial statements at various points throughout the year. Interim Financial Statements Preparing Financial Statements Covering Different Periods of Time

Ethics, Fraud, and Corporate Governance A company should disclose any facts that an intelligent person would consider necessary for the statements to be interpreted properly. Public companies are required to file annual reports with the Securities and Exchange Commission (SEC). The SEC requires that companies include a section labeled “Management Discussion and Analysis” (MD&A) because the financial statements and related notes may be inadequate for assessing the quantity and sustainability of a company’s earnings.

The End