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THE ACCOUNTING CYCLE

(PART 2)
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Mini Quiz
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THE ACCOUNTING CYCLE

1 2 3

Analyze Journalize Posting to

Transactions Transactions Ledgers

6 5 4

Preparation of
Preparation of
Adjusted Trial Adjusting Entries
Trial Balance
Balance

7 8 9

Prepare Financial After-Closing

Closing Entries
Statements Trial Balance
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THE TRIAL BALANCE

▫ A trial balance is a list of accounts and their balances
at a given time. Contains both statement of financial
position and income statement accounts.
▫ The primary purpose of a trial balance is to prove the
mathematical equality of debits and credits after
posting.
▫ A trial balance also uncovers errors in journalizing and
posting.
▫ The procedures for preparing a trial balance consist of
1. listing the account titles and their balances,
2. totaling the debit and credit columns, and
3. proving the equality of the two columns.
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USES AND LIMITATIONS OF THE TRIAL
BALANCE
▫ The equality of debits and credits gives assurance that:
- Equal debits and credits have been recorded for all
transactions
- The account balances have been calculated properly.
▫ If debits and credits do not agree, then an error has been made,
typically:
- Posting of a debit as a credit, or vice versa
- Arithmetic mistakes in determining account balances
- Clerical errors in copying account balances into the trial
balance
- Listing a debit balance in the credit column of the trial balance
- Errors in addition of the trial balance
▫ Note that the preparation of a trial balance does not prove that
transactions have been correctly analyzed and recorded in the
proper accounts.
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STEPS
General Journal
Date Accounts Debit Credit
Jan 1 2020 Cash 1,000,000
Capital Stock 1,000,000
Jan 2 2020 Equipment 500,000
Cash 500,000
Jan 3 2020 Cash 50,000
Revenue 50,000

Cash – General Ledger Trial Balance

Date Debit Credit Account Debit Credit
Jan 1 2020 1,000,000 Cash 550,000
Jan 2 2020 500,000 Equipment 500,000

Jan 3 2020 50,000 Capital Stock 1,000,000

Subtotal 1,050,000 500,000 Revenue 50,000

Total 550,000 TOTAL 1,050,000 1,050,000

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Questions?
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Gil Billy Willy

Case Discussion
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THE ACCOUNTING CYCLE

1 2 3

Analyze Journalize Posting to

Transactions Transactions Ledgers

6 5 4

Preparation of
Preparation of
Adjusted Trial Adjusting Entries
Trial Balance
Balance

7 8 9

Prepare Financial After-Closing

Closing Entries
Statements Trial Balance
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ADJUSTING ENTRIES: APPLICABLE

ACCOUNTING CONCEPTS
Revenue recognition
Time Period principle Matching principle
principle

• Assumes that the economic
life of a business can be
divided into artificial time
periods — generally a month,
a quarter, or a year.
• Interim periods – periods
less than a year
• Fiscal year – 12-month
period
• Revenue should be recognized
at the time goods are sold or
services are rendered.
• This is the point where the
earnings process is
essentially completed and
the sales value of the goods
or services can be measured
objectively.
• Revenue is recognized when
it is “earned,” regardless on
when a contract is signed or
when cash is received.
• Matching principle is the
concept of offsetting expenses
against revenue on the basis
of cause and effect.
• Expenses are recorded when
they are incurred, regardless
of when payment of cash
occurs.
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ACCRUAL VS CASH BASIS OF
ACCOUNTING
▫ Accrual Basis of Accounting
- Recognizing revenue when it is earned and recognizing
expenses when it is incurred to produce revenues
- Purpose: to measure the profitability of the economic
activities conducted during the accounting period.
▫ Cash Basis Accounting
- Revenue is recognized when cash is collected from the
customer and recognizing expenses when the related
goods or services are used in business operations
- Measures the amount of cash received and paid out
during the period but does not provide a good measure
of profitability`
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ADJUSTING ENTRIES
▫ Purpose: To assign to each accounting period appropriate
amounts of revenue and expense.
▫ Proper measurement of income (and balance sheet items)
over accounting periods allow comparability across periods
and the identification of significant trends.
▫ Adjusting entries are applied on business activities that
cross multiple accounting periods.
▫ Adjusting entries are made only at the end of each
accounting period.
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TYPES OF ADJUSTING ENTRIES

• Prepaid Expenses
Prepayments
• Unearned Revenues
• Accrued Revenues
Accruals
• Accrued Expenses
• Depreciation
Estimates
• Valuation adjustments

PREPAYMENTS: PREPAID EXPENSES
▫ Prepaid Expenses are expenses
paid in cash and recorded as
assets before they are used or
consumed.
▫ Prepaid expenses expire with the
passage of time or through use
and consumption.
- When Prepaid Expenses
expire, they are expensed.
- An asset-expense account
relationship exists with
prepaid expenses.
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▫ Prior to adjustment: Assets are
overstated and Expenses are
understated.
▫ Adjusting Entry:
- Debit to an expense account
- Credit to an asset account
▫ Examples: supplies, rent,
insurance, and property tax.

PREPAYMENTS: UNEARNED REVENUES
▫ Unearned revenues are revenues
received and recorded as
liabilities before they are earned.
▫ Unearned revenues are
subsequently earned by
performing a service or providing
a good to a customer.
- A liability-revenue account
relationship exists with
unearned revenues.
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▫ Prior to adjustment, liabilities are
overstated and revenues are
understated.
▫ Adjusting entry:
- Debit to a liability account
- Credit to a revenue account
▫ Examples: rent, magazine
subscriptions, airplane tickets,
and tuition.

ACCRUALS: ACCRUED REVENUES
▫ Accrued revenues may
accumulate with the passing of
time or through services
performed but not billed or
collected.
▫ An asset-revenue account
relationship exists with accrued
revenues.
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▫ Prior to adjustment, assets and
revenues are understated.
▫ Adjusting entry:
- Debit to an asset account
- Credit to a revenue account
▫ Examples: accounts receivable,
rent receivable, and interest
receivable.

ACCRUALS: ACCRUED EXPENSES
▫ Accrued expenses are
expenses incurred but not
yet paid.
▫ A liability-expense account
relationship exists.
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▫ Prior to adjustment, liabilities
and expenses are understated.
▫ Adjusting Entry:
- Debit to an expense account
- Credit to a liability account
▫ Examples: accounts payable, rent
payable, salaries payable, and
interest payable.

DEPRECIATION
▫ Depreciation is the systematic
allocation of the cost of a
depreciable asset to expense
over the asset’s useful life.
▫ Purpose: To offset a reasonable
portion of the asset’s cost
against revenue in each period of
the asset’s useful life (matching
principle).
▫ This is not an attempt to
estimate the asset’s market
value.
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▫ The amount of depreciation is
just an estimate. It does not
precisely determine the actual
expiration of the economic
usefulness of an asset. The
following are estimated:
- Rate of asset depreciation (or
depreciation method)
- Salvage value, if any
- Useful life

DEPRECIATION
▫ Adjusting entry:
- Debit Depreciation Expense
- Credit Accumulated
Depreciation (a contra-asset
account)
▫ Note that the asset account is not
directly reduced.
▫ Net Book Value
- The difference between the
cost of the asset and its
related accumulated
depreciation
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- Represents costs to be
offset against revenue in
future periods.
- Gives indication of the age
of depreciable assets
▫ Depreciation is a noncash
expense
▫ This often represents the largest
difference between profit and
cash flow from business
operations.
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SUMMARY OF ADJUSTING ENTRIES

Type of Adjusting Entry Situation Adjusting Entry

Dr. Expense xxx
Prepaid Expenses Asset Expense
Cr. Asset xxx
Dr. Liability xxx
Unearned Revenues Liability Revenue
Cr. Revenue xxx
Dr. Asset xxx
Accrued Revenues Asset Revenue
Cr. Revenue xxx
Dr. Expense xxx
Accrued Expenses Liability Expense
Cr. Liability xxx
Dr. Expense xxx
Depreciation Asset Expense
Cr. Contra Asset xxx

LEGEND:

Overstated Understated
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EFFECT OF ADJUSTING ENTRIES ON
FINANCIAL STATEMENTS
Income Statement Statement of Financial Position
Adjustment
Revenue Expenses Profit Assets Liabilities Equity

Prepaid Expenses No effect No effect

Unearned Revenues No effect No effect

Accrued Revenues No effect No effect

Accrued Expenses No effect No effect

Depreciation No effect No effect

LEGEND:

Increase Decrease
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MATERIALITY PRINCIPLE
▫ Materiality refers to the relative importance of an item
or an event. Financial reporting process should be
cost-effective.
▫ “Material” if knowledge of the item might reasonably
influence the economic decisions of users of financial
statements.
▫ Implication:
- All material items should be properly reported in
the financial statements.
- Immaterial items may be handled in the easiest
and most convenient manner.
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MATERIALITY PRINCIPLE
▫ This principle enables accountants to shorten and
simplify the process of making adjusting entries.
▫ Examples:
- Low-cost or easily-consumed items can be
expensed immediately
- Costs such as utility bills may be charged to
expenses as the bills are paid, rather than as the
services are used (cash basis)
- Immaterial unrecorded expenses or unrecorded
revenues may be ignored.
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MATERIALITY CONSIDERATIONS
▫ Materiality is a matter of professional judgment.
- “Material” amount varies with the size of the
organization.
- Cumulative effect of numerous immaterial events.
- Materiality depends on the “nature” of the time and
its dollar amounts (e.g. fraud, stealing company
assets)
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Questions?
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Do It All Solutions
Case Discussion