Chapter 3

Chapter 3

The Accounting Cycle

Started business with 35,000 $ by Mr.Ali Purchase Equipments for 2,000$ cash Services provided to customers for 4,000$,

cash received only 1,000$ Rent of building paid 700$ Car purchased for 12,000 cash paid 3,000$ Fuel bill received for 300$ but the amount is

not yet paid Bank loan taken 15,000$ Cash paid 5,000$ to person from whom we

purchased car Cash received from A/R 1500$

Complete Accounting Cycle

Business Transactions

Ledger Accounts

Journal

Trial Balance

Trial Balance (After closing entries)

Adjusting Entries

Adjusted Trial Balance

Financial Statement

Closing Entries

The Journal

In an actual Accounting System, the information regarding each business transaction in initially recorded in a book called Journal.

The Journal

The word “Journal” is actually derived from a word “Journ” that means day..

Hence Journal means “daily”.

Because of daily transactions are recorded here on day to day basis therefore this book called Journal.

The Journal

Journal also called the “book of original entry”, because the business transaction are first of all recorded here.

In Journal all the transaction are recorded on chronological basis.

Debit (Dr) &Credit (Cr)

Debit means “Left”

Credit means “Right”

Debit & Credit(Dr…Cr.)

Debit means “that comes into the business”

Credit means “that goes out from the business”


Debit:

The Debit is derived from a word “Debare” which means “to owe”


Credit:

This word is derived from word “Credere” and that means “to be owed”


There is no specific meaning of Dr. and Cr.

They are just the signs to follow the accounting rules/principles and that's all.

Head of Accounts

1. Assets

2. Expenses

3. Owner’s Equity

4. Liabilities

5. Revenues

Rules of Dr. and Cr.

Assets

Expenses

Owner’s Equity

Liabilities

Revenues

Increase……. DebitDecrease……Credit

Increase……. DebitDecrease……Credit

Increase……. CreditDecrease…… Debit



Rules of Dr. and Cr.

Assets Expenses

Owner’s Equity Liabilities Revenues

Increase.......DrDecrease…..Cr

Increase....... CrDecrease….. Dr

Journal Entry

Recording the business transaction in initial book of accounts according to the rules of Dr. and Cr is called Journal Entry

Methodology of making a Journal Entry

1. Analyze the business transaction

2. Determine the rules regarding such transaction

3. Make the Journal Entry

Journal Entry

Date Inv. No Description L/F Debit Credit

13th

MarchCash Bank Loan

$ 40,000

$ 40,000

March 13th.The business takes a loan form bank of $ 40,000.


Date Analysis Rules Journal Entry

Dr. Cr.



Date Analysis Rules Journal Entry

13th March Increase in Cash (Asset)

Increase in Bank Loan (Liability)

Increase in Assets..(Dr.)

Increase in Liability..(Cr.)

Cash

B. Loan

Dr. Cr.

$ 40,000

$ 40,000


Journal Entry

Date Inv. No Description L/F Debit Credit

Why use Journal….?

1. The Journal shows all information of a transaction in one place and also provide and explanation of it.

2. The Journal provides a chronological record of all the events in the life of business

3. The use of Journal helps to prevent errors

Posting

The process of transferring the Dr. and Cr. From Journal to Ledger Accounts is called “posting”.

The Ledger/ Account/ T account

A separate record for each item like cash, bank, liability, salaries, sales etc is called “Ledger”, or “Account” or some times called “T account”.

Ledger Accounts

_______ Ledger AccountNo…. 3 (e.g.)

Date Description Amount Date Description Amount

Total Total

Dr. Cr.

Ledger Accounts or “T” Account

_______ Ledger AccountNo…. 3 (e.g.)

Dr. Cr.

Trial Balance

Before using the account’s balances to prepare financial statements, it is desirable to prove that the accounts with Dr balances are in fact equal to the total of Cr balances.

This proof of equality of Dr and Cr balances is called Trial Balance.

Trial Balance

Trial: means to check before finalizing….that's why its called Trial Balance because it checks that balances are equal or not

Note: about Trial Balance

If the balances of Dr and Cr sides are not equal it means you have made some error.

But if the balances or Dr and Cr are equal it doesn’t mean that you have made no error.

Robert Real Estate CompanyTrial Balance

for the month of March 2009

S/No L/No Items Dr Cr

1

2

3

4

5

6

7

8

9

10

11

12

Cash

Accounts receivable

Land

Building

Office equipment

Accounts payable

Capital: James Roberts

Drawings: James Roberts

Sales Commission earned

Advertising expenses

Salaries expenses

Telephone expenses

$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

23,814

181,000

10,640

Total $ 215,274 $ 215,274

What is Net Income…?

A increase in owner’s equity resulting from the profitable operation of business(loss is inverse of this)

The Income Statement

A statement that shows the Profit or Loss of the business for a specified period of timeAnd it contains:

1. Revenue &2. Expenses

Income Statement

ROBERTS REAL ESTATE COMPANYIncome Statement

For the month ended February 2009______________________________________________________________

Revenue:Sales commission earned………………………………… $ 10640

Less; Expenses:Advertising expense…………………………… $ 630Salaries expense………………………….......... 7,100Telephone expense…………………………….. 144Depreciation expense: building……………… 150Depreciation expense: office equipment.. 45 (8,069)

Net Income……………………………………………………………….. $ 2,571

Revenue

Revenue is the price of goods sold & services rendered during a given accounting period.

It may be:Sales Commission receivedInterest receivedFees earned etc

When to record Revenue…?

Realization Concept:

When received the order…?

When transfer the goods/ rendered the services…?

When received the amount…?

When the ownership is transferred.

Expenses

Expenses are the cost of goods and services used up in the process of earning revenue.

When to record Expenses…?

Matching Principle:

In measuring Net Income for a period, revenue should be offset by all the expenses incurred in producing that revenue.

This concept of offsetting expenses against revenue on a basis of “cause & effect” is called the Matching Principle.

Expenditures benefiting more than one Accounting period

Many expenditures made by a business benefit two or more accounting periods.In such situation we need to apportion the stated expenditure for matching it with the related revenue.

Adjusting Entries:The next step in the Accounting Cycle

Many transactions affect the revenue or expenses of two or more accounting periods.

How do the accountants allocate the cost of these assets to expense over a span of several accounting periods?

The answer is Adjusting entries.

Adjusting Entries:

Adjusting Entries are made at the end of each accounting period. Such entries allocate the actual revenue earned in a specific accounting period and relevant expenses.

There are several different types of adjusting entries; in fact, many businesses make a dozen or more adjusting entries at the end of every accounting period.

Robert Real Estate CompanyTrial Balance



1

2

3

4

5

6

7

8

9

10

11

12

Cash

Accounts receivable

Land

Building

Office equipment

Accounts payable





Salaries expenses

Telephone expenses

$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

23,814

181,000

10,640

Total $ 215,274 $ 215,274

Adjusting entry

Description R/No Dr. Cr.

Depreciation expenses: building

Accumulated Depreciation: building…..

$ 150$ 150

Recording depreciation of Building:

Calculation: Price of Building = 36,000

Number of years = 20 years

36,000/20 = 1800 (per year depreciation)

1800/12 = 150 (per month depreciation)

Adjusting entry

Recording depreciation of Office equipment:Calculation: Price of equipment = 5,400

Number of years = 10 years

5,400/10 = 540 (per year depreciation)

540/12 = 45 (per month depreciation)


Depreciation expenses: O. Equipment

Accumulated Depreciation: O. Equipment

…..$ 45

$ 45

Robert Real Estate CompanyAdjusted Trial Balance



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

Cash

Accounts receivable

Land

BuildingAccumulated Depreciation: Building

Office equipmentAccumulated Depreciation: equipment

Accounts payable





Salaries expenses

Telephone expenses

Depreciation expense: building

Depreciation expense: equipment

$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

150

45

150

45

23,814

181,000

10,640

Total $ 215,649 $ 215,649

Preparation of Financial Statements

Income Statement Statement of Owner’s Equity Balance Sheet

Income Statement

A statement that shows the profit or loss of the business for a specific time period. This statement consisting;

Revenue for the accounting period Expenses for the accounting period

ABC CorporationAdjusted Trial Balance



1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

Cash

Accounts receivable

Land



Accounts payable





Salaries expenses

Telephone expenses



$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

150

45

150

45

23,814

181,000

10,640

Total $ 215,649 $ 215,649

Income StatementROBERTS REAL ESTATE COMPANY

Income StatementFor the month ended March 30th, 2009

______________________________________________________________

Revenue:Sales commission earned………………………………… $ 10640

Less; Expenses:Advertising expense…………………………… $ 630Salaries expense………………………….......... 7,100Telephone expense……………………………. 144Depreciation expense: building……………… 150Depreciation expense: office equipment.. 45 (8,069)

Net Income……………………………………………………………….. $ 2,571*

* It is a part of owner’s equity because is to be paid to owner of the business

Statement of Owner’s Equity

This statement shows the obligation of business to its owner. This statement consisting ;

Capital invested by owner Profit of the current accounting period Drawings of the owner




1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

Cash

Accounts receivable

Land



Accounts payable





Salaries expenses

Telephone expenses



$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

150

45

150

45

23,814

181,000

10,640

Total $ 215,649 $ 215,649

ROBERT REAL ESTATE COMPANYStatement of Owner’s Equity

as on March 30th, 2009

Capital: James Robert…….... $ 181,000Add: Profit for the period........ 2,571*

$ 183,571 Less: Drawings: ……………... 2,800

Net Owner’s Equity…….......... $ 180,771

* Form Income Statement

Balance Sheet

That statement which shows the financial position of the business on a particular time is called “Balance Sheet”. This statement shows the resources of the business as well as the obligation of the business.

Balance sheet consisting; Assets of the business Liabilities of the business Owner’s Equity




1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

Cash

Accounts receivable

Land



Accounts payable





Salaries expenses

Telephone expenses



$ 15,490

17,890

130,000

36,000

5,400

2,800

630

7,100

144

150

45

150

45

23,814

181,000

10,640

Total $ 215,649 $ 215,649

ROBERT REAL ESTATE COMPANYBalance Sheet

as on March 30th, 2009

Assets:

Cash ………………………………………………………… $ 15,490

Accounts receivable…………………………………..…… 17,890

Land………………………………………………………..…. 130,000

Building…………………………………………. 36,000

Less: Accumulated Depreciation: Building… (150) 35,850

Office equipment…………………………......… 5,400

Less: Accumulated Depreciation: equipment.. (45) 5,355

Total Assets……………………………………………………………. $ 204,585

Liabilities:

Accounts Payable…………………………………............... $ 23,814

Owner’s Equity:

James Roberts……………………………………………….. $ 180,771

Total Liabilities & Owner’s Equity…………………………….. $ 204,585

Temporary Accounts

Revenues increase the owner’s equity and expenses and drawings decreases it.

If the only financial statement we needed was a balance sheet, these changes in owner’s equity could be recorded directly in the owner’s equity capital account.

However managers, investors, and other need to know amounts of specific revenue and expenses, and the amount of net income earned in the period.

Therefore, we maintain separate ledger accounts to measure each type of revenue and expense, and owner’s drawings.

These revenues, expense, and drawings accounts are called Temporary Accounts, or Nominal Accounts.

Because it accumulate the transactions of only one accounting period

The Owner’s Capital account and other balance sheet accounts are called Permanent or Real Accounts

Because their balances continue to exist beyond the current accounting period.

Permanent Accounts

Closing of Temporary Accounts

The process of transferring the balances of the temporary accounts into the owner’s permanent capital account is called Closing the temporary accounts.

The journal entries made for the purpose of closing the temporary accounts are called closing entries.

Closing Process

1. Close the various revenues accounts by transferring their balance into the Income Summary account.

2. Close the various expenses accounts by transferring their balances into the Income Summary Account.

3. Close the Income Summary Account by transferring its balance into the owner’s capital account.

4. Close the owner’s drawing account into the owner’s capital account.(The balance of the owner’s capital account in the ledger will now be the same as the amount of owner’s equity appearing in the balance sheet)

Closing Process:

All RevenuesAll Expenses

Income Summary

Owner’s DrawingsOwner’s Capital

Account

Closing Entries for Revenue

All the revenue are to be closed into income summary account by; Debit all the revenues account Credit the Income Summary account


All revenues a/c

Income Summary a/c…..

$ XXXX$ XXXX

Closing Entries for Revenue

There is only one source of revenue in our illustration and that is :

Sales commission earned………….. $ 10,640


Sales Commission Earned

Income Summary…..

$ 10,640$ 10,640

Closing Entries for Expenses

All the expenses are also required to be closed into the Income Summary account by; Debit the Income Summary account and Credit all the expenses account


Income Summary a/c

All expenses a/c…..

$ XXXX$ XXXX

Closing Entries for Expenses

Expenses are in our illustration are:

1. Advertising Expense

2. Salaries Expenses

3. Telephone expenses

4. Depreciation expenses: building

5. Depreciation expenses: office equipment


Income Summary

Advertising Expense

Salaries Expenses

Telephone expenses

Depreciation expenses: building

Depreciation expenses: office equipment

(closing of all the expenses accounts)

$ 8,069$ 630

7,100

144

150

45

Closing of the Income Summary Account

Income Summary account is also a temporary account hence we are also required to close it to the Owner’s Capital Account.

Because Income Summary account gives us the profit or loss of the business for a specific time period, and such profit or loss will be a part of owner’s equity.

Closing the Income Summary Account by; Debit the Income Summary Account (if profit) Credit the Owner’s Capital Account ( if profit)

(if loss it would be inversed)


Income Summary a/c

Owner’s Capital a/c…..

$ XXXX$ XXXX

Closing Entry of Income Summary Account

In our illustration we have a profit as by our Income Summary i.e. $ 2,571.


Income Summary a/c

Owner’s Capital a/c…..

$ 2,571$ 2,571

Closing Entries Owner’s Drawings account

Owner’s drawings account is also required to be closed. We have to close such account with Owner’s Capital account by; Debit the Owner’s Capital Account and Credit the Owner’s Drawing Account


Owner’s Capital a/c

Owner’s Drawing a/c…..

$ XXXX$ XXXX

Closing Entries Owner’s Drawings account

In our illustration there is only one Drawing account of $ 2,800.


Owner’s Capital a/c

Owner’s Drawing a/c…..

$ 2,800$ 2,800

ABC CorporationAfter Closing Trial Balance



1

2

3

4

5

6

7

8

9

Cash

Accounts receivable

Land



Accounts payable

Capital: James Roberts(as per statement of Owner’s Equity)

$ 15,490

17,890

130,000

36,000

5,400

150

45

23,814

*181,771

Total $ 215,649 $ 215,649

Summary of the Closing Process

1. Close the various revenues accounts by transferring their balance into the Income Summary account.

2. Close the various expenses accounts by transferring their balances into the Income Summary Account.

3. Close the Income Summary Account by transferring its balance into the owner’s capital account.

4. Close the owner’s drawing account into the owner’s capital account.(the balance of the owner’s capital account in the ledger will now be the same as the amount of owner’s equity appearing in the balance sheet.

Closing Process:

All RevenuesAll Expenses

Income Summary

Owner’s DrawingsOwner’s Capital

Account

Sequence of procedures in the Accounting Cycle

1. Journalize transaction

2. Post to Ledger accounts

3. Prepare a Trial Balance

4. Make end-of-period Adjustments

5. Prepare adjusted Trial Balance

6. Prepare Financial Statements

7. Journalize and post the Closing entries

8. Prepare an after-closing Trial Balance.

Complete Accounting Cycle

Business Transactions

Ledger Accounts

Journal

Trial Balance

Trial Balance (After closing entries)

Adjusting Entries

Adjusted Trial Balance

Financial Statement

Closing Entries

End of Chapter 3 End of Chapter 3

Chapter 3

Documents

Transcript of Chapter 3