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Topic 2: The Accounting

Cycle

Debits and Credits

• Double-entry accounting system (two-sided effect)

• Recording done by debiting at least one account and
crediting another
• DEBITS must equal CREDITS
• Shows the effect of transactions on a given asset, liability,
equity, revenue, or expense account

Normal Balance Debit? Normal Balance Credit?

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Accounting Identity
Assets = Liabilities + Owners’ Equity
Assets - economic resources that the firm controls
- Cash/investment securities
- Accounts receivable
- Inventory
- Property, plant and equipment
- Intangibles

Liabilities - creditors’ claims on the assets of the firm

- Loans from banks
- Accounts payable (amounts due to vendors/suppliers)
- Compensation payable (amounts due to employees)
- Income taxes payable (amounts due to government)

Owners’ Equity (OE) - residual claims of the firm’s owners

Assets = Liabilities + Owners’ Equity

Public company (with publicly traded stock): shareholders =

owners

Shareholders are the residual claimants on the firm’s

assets, after the creditors
• OE + Net contributed capital = Retained earnings

Net contributed capital = Accumulated capital contributed

to the firm by owners less payments to owners to
repurchase shares since inception

Retained earnings = Accumulated earnings of the firm

less accumulated dividend payments since inception

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A = L + OE (ALWAYS)

At = Lt + OEt

Journal entries are recorded to asset, liability,

and OE accounts.

The entries change the accounts.

At+1 = Lt+1 + OEt+1

Examples of activities during t+1

Use one asset (cash) to acquire another (e.g., a machine):

At = Lt + OEt At+1 = At+1 At+1 = Lt+1 + OEt+1

Borrow money from a bank:

At = Lt + OEt At+1 = Lt+1 At+1 = Lt+1 + OEt+1

Earn revenue by providing a service and receiving compensation for doing so:
At = Lt + OEt At+1 = OEt+1 At+1 = Lt+1 + OEt+1

Incur a current-period cost:

At = Lt + OEt At+1 = OEt+1 At+1 = Lt+1 + OEt+1
Lt+1 = OEt+1

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Changes in Owners Equity

At = Lt + OEt Reported on the balance sheet

At+1 = Lt+1 + OEt+1

Net capital contributions (e.g., new shares, dividends)
* Recorded to permanent OE accounts

Performance-related changes (e.g., earn revenue)

ΔAt+1 = ΔLt+1 + ΔOEt+1 * Recorded to temporary OE accounts (e.g., revenue)
* Later transferred (closed) to a permanent OE account
(Retained earnings)

Reported on the income statement

Accounting Cycle (Summary Preview)

1. Record and post basic “transactions”
• Debits/credits
2. Prepare an unadjusted Trial balance (T/B)
• Includes all accounts
• Merely summarizes balances
3. Record and post adjusting entries
• Subsequent measurement
• Recording “non-transactions”
4. Prepare an adjusted T/B
• Includes all accounts
• Balances should be “right” (measured in accordance w/ GAAP rules & error free)
5. Prepare Income statement (I/S)
• Using only the revenue and expense and gain and loss accounts on the trial balance
6. Record and post closing entries
• Move balances of temporary “income statement” accounts to Retained earnings (OE)
7. Prepare a closed T/B
• Includes only B/S accounts, because temporary accounts were zeroed out in previous step
8. Prepare Balance sheet

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Accounting Cycle
1. Record and post basic “transactions”
• Debits/credits

Assume a liability and acquire an asset:

Earn revenue by providing a service and receiving compensation for doing so:

Incur a current-period cost:

*Remember: Revenue and expense are temporary OE accounts

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Accounting Cycle
1. Record and post basic “transactions”
• Debits/credits
Post to general ledger:
GENERAL LEDGER
Account: Acct. No. ##
Balance
Post.
Date Item Ref. Debit Credit DR (CR)

Oct 1 Cash 101 100,000 100,000

GENERAL LEDGER
Account: Acct. No. ##
Balance
Post.
Date Item Ref. Debit Credit DR (CR)

Oct 1 Loan Payable 311 100,000 (100,000)

The “T” account is a shorthand format of an account

used by accountants to analyze transactions.

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Accounting Cycle

2. Prepare an unadjusted Trial balance (T/B)

• Includes all accounts
• Merely summarizes balances

Balanced

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Accounting Cycle

3. Record and post adjusting entries

• Subsequent measurement
• Recording “non-transactions”

Deferrals Accruals Estimates

Transactions where cash is Transactions where cash is Accountants must often

paid or received before a paid or received after a make estimates in order to
related expense or revenue is related expense or revenue is comply with the accrual
recognized. recognized. accounting model.

Examples: Prepaid expenses, Unearned revenue, Accrued interest, Accrued

salaries & wages, Bad debt expense, Depreciation expense, Fair value
adjustments

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Sample Adjusting Journal Entries

1. Adjusting prepaid expense (using insurance):

2. Adjusting unearned revenue (recognize previously unearned):

3. Adjusting accrued interest (incurred but not paid):

4. Depreciation (machine is being used and getting older):

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Accounting Cycle
1. Record and post basic “transactions”
• Debits/credits
2. Prepare an unadjusted Trial balance (T/B)
• Includes all accounts
• Merely summarizes balances
3. Record and post adjusting entries
• Subsequent measurement
• Recording “non-transactions”
4. Prepare an adjusted T/B
• Includes all accounts
• Balances should be “right” (measured in accordance w/ GAAP rules & error free)
5. Prepare Income statement (I/S) → Next week
• Using only the revenue and expense and gain and loss accounts on the trial balance

6. Record and post closing entries

• Move balances of temporary “income statement” accounts to Retained earnings (OE)

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Accounting Cycle
6. Record and post closing entries
• Move balances of temporary “income statement” accounts to Retained earnings (OE)

Example closing entries:

Close revenue accounts
DR. Sales Revenue 15,000
DR. Interest Revenue 5,000
CR. Income summary 20,000
Close expense accounts
DR. Income Summary 12,000
CR. Supplies Expense 3,000
CR. Depreciation Expense 2,000
CR. Salaries Expense 7,000
Close net income to retained earnings
DR. Income Summary 8,000
CR. Retained Earnings 8,000

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Accounting Cycle

1. Record and post basic “transactions”

• Debits/credits
2. Prepare an unadjusted Trial balance (T/B)
• Includes all accounts
• Merely summarizes balances
3. Record and post adjusting entries
• Subsequent measurement
• Recording “non-transactions”
4. Prepare an adjusted T/B
• Includes all accounts
• Balances should be “right” (measured in accordance w/ GAAP rules & error free)
5. Prepare Income statement (I/S)
• Using only the revenue and expense and gain and loss accounts on the trial balance
6. Record and post closing entries
• Move balances of temporary “income statement” accounts to Retained earnings (OE)
7. Prepare a closed T/B
• Includes only B/S accounts, because temporary accounts were zeroed out in previous step
8. Prepare Balance sheet → Week 3

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Example Problem: JEs for transactions

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.

What’s the entry?

2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year

policy.

What’s the entry?

3. June 22, 2019 Paid $5,000 on an outstanding account payable.

What’s the entry?

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Example Problem: JEs for transactions

4. July 17, 2019 Purchased supplies costing $2,800 on account. At the

December 31, 2019 year end, supplies costing $1,250 remained on
hand.

What’s the entry?

5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company

estimates depreciation for the remainder of the year to be $500.

What’s the entry?

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.

2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.

3. June 22, 2019 Paid $5,000 on an outstanding account payable.

4. July 17, 2019 Purchased supplies costing $2,800 on account. At the

December 31, 2019 year end, supplies costing $1,250 remained on hand.

5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company

estimates depreciation for the remainder of the year to be $500.

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.
2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.
3. June 22, 2019 Paid $5,000 on an outstanding account payable.
4. July 17, 2019 Purchased supplies costing $2,800 on account. At the
December 31, 2019 year end, supplies costing $1,250 remained on hand.
5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company
estimates depreciation for the remainder of the year to be $500.

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.
2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.
3. June 22, 2019 Paid $5,000 on an outstanding account payable.
4. July 17, 2019 Purchased supplies costing $2,800 on account. At the
December 31, 2019 year end, supplies costing $1,250 remained on hand.
5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company
estimates depreciation for the remainder of the year to be $500.

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.
2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.
3. June 22, 2019 Paid $5,000 on an outstanding account payable.
4. July 17, 2019 Purchased supplies costing $2,800 on account. At the
December 31, 2019 year end, supplies costing $1,250 remained on hand.
5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company
estimates depreciation for the remainder of the year to be $500.

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.
2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.
3. June 22, 2019 Paid $5,000 on an outstanding account payable.
4. July 17, 2019 Purchased supplies costing $2,800 on account. At the
December 31, 2019 year end, supplies costing $1,250 remained on hand.
5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company
estimates depreciation for the remainder of the year to be $500.

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Example Problem: Adjusting JEs

1. February 1, 2019 Borrowed $12,000 from a bank and signed a note.

Principal and interest at 10% will be paid on January 31, 2020.
2. April 1, 2019 Paid $3,600 to an insurance company for a 2-year policy.
3. June 22, 2019 Paid $5,000 on an outstanding account payable.
4. July 17, 2019 Purchased supplies costing $2,800 on account. At the
December 31, 2019 year end, supplies costing $1,250 remained on hand.
5. Nov 1, 2019 Purchased a machine for $10,000 cash. The company
estimates depreciation for the remainder of the year to be $500.

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Questions?

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