Completing the Accounting Cycle

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Completing the Accounting Cycle

• Lecture Four

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Learning Objectives

• Prepare and use an accounting work sheet to
  complete the accounting cycle
• Close the revenue, expense and drawings accounts
• Correct typical accounting errors
• Reversing Entries
• Classify Assets Liabilities
• Use the current and debt ratios to evaluate a
  business
• Other Issues
• Profit Recognition
• Measurement
• Disclosure

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Objective 1 Accounting Work Sheet

• The accounting cycle is the process by which
  accountants produce the financial statements for
  a specific period of time
• Work is performed at two different times
• During the period
• journalising transactions and posting to the
  ledger
• End of the period
• Adjusting entries
• Closing entries
• Preparing financial statements

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Work Sheet

• A multi-column document, a work sheet, summarizes
  the effects of all the periods activity
• Facilitates the calculation of periodic
  profit/loss
• Convenient device for completing the accounting
  cycle
• It is NOT a journal or ledger
• Actual adjustments of the accounts MUST be
  journalised and posted to the accounts
• It is an internal document only it is NOT an
  auditable legal document
• Closing entries can also be prepared at this time

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Worksheet
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Work Sheet Entering Adjusting Entries

• Enter the following adjusting entries
• Sales earned for the period is 10,000
• Dr Sales 5,000
• Cr Unearned Revenue 5,000
• Wages owing but not paid 2,500
• Dr Wages Expense 2,500
• Cr Accrued Wages 2,500
• Doubtful debts are estimated to be 750
• Dr Doubtful Debts Expense 750
• Cr Allowance for Doubtful Debts 750

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Worksheet
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Worksheet
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Objective 2 Closing Entries

• Closing the accounts is the end of period process
  that prepares the accounts for recording
  transactions during the next period. Revenues,
  expenses, drawings and increments to capital
  represent increases and decreases in owners
  equity during a specific period
• At the end of an accounting period nominal
  (temporary) accounts are closed out returned to
  a zero balance
• .
• .
• .
• Only permanent accounts remain open and their
  balances carried forward to the next period
• .
• .
• Follows the going concern, time period and
  matching principles

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Closing Entries

• Close ALL revenue and expense accounts to the
  Income Summary Account (Profit and Loss Summary
  Account)
• Close Income Summary Account (net profit/loss) to
  Owners Equity
• Close drawings to Owners Equity

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Closing Entries

• Refer Worksheet Example (Slide 8)
• Sales revenue 10,000
• Income Summary 10,000
• Income Summary 3,495
• Telephone exp. 245
• Wages exp. 2,500
• Doubtful debts exp. 750
• 3. Income Summary 6,505
• Capital 6,505

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Post-closing Trial Balance

• The accounting cycle ends with the post-closing
  trial balance.
• The post-closing trial balance is dated as of the
  end of the period for which the statements have
  been prepared.
• What accounts will a post-closing trial balance
  show?

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Objective 3 Correct Typical Accounting Errors

• Accountants correct errors by making correcting
  journal entries
• Errors can arise at any stage of processing
• Journal stage - it is necessary only to rewrite
  the entries to reflect the correction
• After posting to the general ledger - a
  correcting general journal entry is required
• .

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Example 1 Correct Accounting Error

• Transaction was for 500 not 5,000
• At journal stage error detected prior to
  posting
• Cross out entry and initial

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Example 2 Correct Accounting Error

• Transaction was for 500 not 5,000
• Error detected after posting
• Correcting entry required

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Objective 4 Reversing Entries

• Are special types of entries that facilitate the
  accounting process for the new accounting period
• Relate to accrued revenue and expenses
• Reverses a previous adjusting entry
• Not required but they save accountants having to
  remember that part of a payment or receipt in the
  next period relates to the previous period.

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Reversing Entry Example

• Assume wages of 15,000 have been paid during
  the period. An additional 10,000 needs to be
  accrued at the end of the period (30/6/07) i.e.
  earned but not paid
• 1. Adjusting Entry

Wages Payable
Wages Expense
Cash
10,000
15,000
15,000
10,000
10,000
25,000
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Reversing Entry Example

• 2. Closing Entry

Wages Payable
Wages Expense
Cash
10,000
15,000
15,000
25,000
10,000
10,000
0
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Reversing Entry Example

• 3. Wages Paid Next Period (example 1 without
  reversing entry but correct allocation)

Wages Payable
Wages Expense
Cash
10,000
15,000
10,000
4,000
14,000
4,000
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Reversing Entry Example

• 3. Wages Paid Next Period (example 2 without
  reversing entry and incorrect allocation)

Wages Payable
Wages Expense
Cash
10,000
15,000
14,000
14,000
10,000
14,000
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Reversing Entry Example

• 3. Wages Paid Next Period (with reversing journal
  entry)

Wages Payable 10,000 dr Wages Expense 10,000
cr
Wages Payable
Wages Expense
Cash
10,000
10,000
10,000
15,000
14,000
14,000
0
4,000
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Objective 5 Classify Assets Liabilities

• On the balance sheet, assets and liabilities are
  classified as either current or non-current to
  indicate their relative liquidity.
• Current assets are cash or can be converted to
  cash within 1 year (or normal business cycle)
• Non current assets are all other assets
• Current liabilities are debts or obligations due
  within 1 year
• Non current liabilities are all other liabilities

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Classify Assets Liabilities

• Balance Sheet Classification
• Current assets are listed in order of decreasing
  liquidity
• Current liabilities are listed in order of how
  soon they must be paid

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Different Formats of theBalance Sheet
Report Format
Account Format
Assets Liabilities Owners Equity
Assets Liabilities
Owners Equity
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Objective 6 Use the current debt ratio to
evaluate a business

• Current and Debt ratios are two common ratios
  that measure liquidity
• Current Ratio measures the ability of a business
  to pay its current liabilities with its current
  assets
• Current ratio current assets/current
  liabilities
• Debt Ratio indicates the proportion of a
  businesss assets that are financed with debt
• Measures the ability to pay both short and
  long-term debt
• Debt ratio total liabilities/total assets

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Use the current debt ratio to evaluate a
business (examples)

• Extract from Balance Sheet

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Use the current debt ratio to evaluate a
business

• Current ratio current assets/current
  liabilities
• 20X4 6304/3932 1.6
• 20X5 6805/4261 1.6
• 20X6 7098/5348 1.3
• Debt ratio - total liabilities/total assets
• 20X4 5151/8268 .62
• 20X5 5252/8868 .59
• 20X6 5968/9695 .62

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Objective 7(1) Profit Recognition

• The profit recognition principle provides
  guidance on the timing and amount of profit to
  record - or more precisely revenue and expense
  recognition.
• Profits should be recorded when earned and not
  before.
• Interest and rent accrue with the passage of
  time.
• Most sales and many services revenue is
  recognised at a point in time.

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Profit Recognition

• In some businesses there are many phases in the
  earning of profits
• from customers ordering to the end of warranty
  period.
• Three conditions for revenue to be recorded (AASB
  118)
• Control of the goods has passed to the purchaser
• Collectibility of the revenue is probable
• Amount can be easily measured

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Profit Recognition

• Four Methods
• Sales method sales for cash and on credit.
• Collection method if receipt of cash is
  uncertain.
• Instalment method for instalment sales -
  provides same overall gross profit as the sales
  method - difference is the period/s in which it
  is recognised.
• Percentage-of-completion method.

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Installment Method

• Real estate developer sells land
• Down payment 200,000 (year 1)
• Annual payments 250,000 (year 2)
• 260,000 (year 3)
• 290,000 (year 4)
• If land cost 660,000
• Gross Profit 1,000,000 660,000 340,000
• GP 340,000/1,000,000 34

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Installment Method
Year Collection x G.P. G.P.
1 200,000 x 34 68,000
2 250,000 x 34 85,000
3 260,000 x 34 88,400
4 290,000 x 34 98,600 Total
1,000,000
340,000
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Percentage-of-Completion Method

• Especially for construction projects that extend
  over several periods.
• Profit is recognised as the work is performed.
• To use this method businesses need to be able to
  reliably estimate both
• The outcome of the contract (profit) and
  percentage of project completed
• Steps
• 1.Calculate of project (divide costs incurred
  this period by total estimated project costs)
• 2. Multiply total project revenue by of
  completion
• 3. Revenue less expenses period profit

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Percentage of Completion Method

• Example
• Energy Corp is building a desalination plant
• Total costs over 3 year project 660,000
  (y1100,000 y2260,000 y3300,000)
• Clients are billed as follows Y1 330,000 Y2
  270,000 Y3 400,000 (Total 1m)
• Calculations
• Costs y1 100,000/660,000 .15
• y2 260,000/660,000 .40
• y3 300,000/660,000 .45
• Revenue y1 1,000,000 .15 150,000
• y2 1,000,000 .40 400,000
• y3 1,000,000 .45 450,000
• Profit y1 150,000 - 100,000 50,000
• y2 400,000 - 260,000 140,000
• y3 450,000 300,000 150,000
• Total Profit 340,000 (1,000,000 660,000)

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Instalment method vs. of Completion Method

• Instalment of Compl.
• Year G.P. GP
• 1 68,000 50,000
• 2 85,000 140,000
• 3 88,400 150,000
• 4 98,600
• Total 340,000 340,000
• Instalment based on collections GP
• of Completion based on expected revenues
  yearly costs/total costs

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Percentage-of-Completion Method

• Where estimates are not possible AASB 111
  Construction Contracts requires
• costs incurred to be recognised as an expense
• Where it is probable cost will be covered by
  revenue
• revenue equal to costs is recognised and nil
  profits reported
• all profits are reported upon completion.
• If a loss is likely on the contract the full
  amount of the expected loss should be taken up
  immediately - even if the construction has not
  commenced.
• An example of conservatism - do not anticipate
  any profits but anticipate all losses.

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Objective 7(2) Measurement Issues

• Transactions are recorded at historical cost -
  what was paid for assets or expenses.
• The information is
• reliable
• relatively easy to identify
• objective
• usually recorded for commercial reasons.

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Measurement Issues

• Historical cost not always used
• AASB 102 allows the write down of inventory if
  their net realisable value falls below purchase
  price.
• AASB 116 allows assets to be revalued to market
  value (up or down)

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Measurement Issues

• Market Value
• Less reliable than historic cost but may be more
  relevant.
• Could increase profits and increase assets, (but
  only if the asset was sold).
• Could increase assets and increase owners equity
• Could disclose market values in the notes and not
  alter the figures in the balance sheet.

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Objective 7(3) Disclosure Policies

• AASB 101 Presentation of Financial Statements,
  requires a summary of accounting policies be
  given in the initial section of the notes.
• The specific accounting principles, bases or
  rules adopted.
• Describe the measurement basic e.g. H.C.
• Give the method of accounting when there is
  choice e.g. method of depreciation.

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Disclosure Policies

• AASB 108 Accounting Policies, Changes in
  Accounting Estimates and Errors
• Consistency is important for comparability.
• If a change is made the company should reveal
• nature of the change
• reason for the change
• effect of the change on net profits.
• Change in accounting policy
• Eg. FIFO to LIFO
• Change in accounting estimate
• Eg. life of an asset is extended

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Disclosure Policies

• AASB 110 Events After the Balance Sheet Date
• There is a period of time between the reporting
  date (end of the financial year) and the
  publishing of the financial statements
  (authorised for issue).
• 2 Types of Events
• Those that provide evidence of conditions that
  existed at the reporting date requires
  adjustment
• Those that are indicative of conditions that
  arose after the reporting date no adjustment
  but requires disclosure if material

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Disclosure Policies

• AASB 110 Events After the Balance Sheet Date
• Adjusting Events
• Settlement of court case
• Asset impairment
• Existing customer declared bankrupt
• Non-adjusting Events
• Decline in market value of investments
• Dividend declaration
• Non-adjusting Events that are material and
  require disclosure
• The nature of the event
• An estimate of the financial effect or statement
  that it cannot be estimated.
• Change in business combination
• Discontinuance of an operation
• Major purchases of assets change in
  classification of assets (for use or for sale)
• Destruction of a major plant/operation