1 Chapter 9 Completing the Accounting Cycle Created by D. Gilroy Heart Lake Secondary School

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Chapter 9

Completing the Accounting Cycle

Created by D. GilroyHeart Lake Secondary School

The Adjustment Process

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The Adjusting ProcessWe now know that financial

statements are used extensively to assist in making business decisions.

It is the accountants responsibility to ensure that these financial statements are accurate, up-to-date, and consistent from year to year.

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The Adjusting ProcessWhen preparing the financial

statements, the accountant must ensure:All accounts are brought up to date;All late transactions are taken into

account;All calculations have been made

correctly; andAll GAAPs have been complied with.

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The Adjusting ProcessBringing the account data up-to-date

at statement time is known as “making the adjustments”.

The accounting entries produced by this process are known as adjusting adjusting entriesentries.

In most cases adjusting entriesadjusting entries assign amounts of revenue or expense to the appropriate accounting period before the books

are finalized for the fiscal period.

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Adjusting entries are necessary because the books of account are allowed to become inaccurate between statements dates.

Some accounts do not need to be perfectly accurate at the end of each business day BUT do need to be adjusted in order to determine the correct net income of net loss for the

period.

The Adjusting Process

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The Adjusting ProcessThe first three adjusting entries are:

Adjusting entries for SuppliesSupplies;Adjusting entries for Prepaid Prepaid

ExpensesExpenses; andAdjusting entries for Late-Arriving Late-Arriving

Purchase InvoicesPurchase Invoices.

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Adjusting Entries for SuppliesWhen supplies are purchased, their cost is

debited correctly to the Supplies account.As supplies are used, which is usually

daily, no accounting entries are made to record this usage.

During the accounting period, the balance of the Supplies account represents the balance at the beginning of the period plus any new supplies purchased.

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Adjusting Entries for SuppliesThe balance of Supplies Expense is zero.In order to satisfy the Matching Principle,

both of these accounts must be adjusted to reflect the usage (i.e. expense) during the fiscal period.

To book the adjusting entry, you must first determine the supplies inventory (by counting the remaining supplies).

You then determine the cost of the supplies used (i.e. difference between the

inventory count and the balance of the supplies account).

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Adjusting Entries for Supplies

2007

2007 2007

6,514 6,514

1,386 6,514

Assume the Supplies on hand at December 31, 2007 are $1,386 (i.e. the supplies inventory).

6,514 6,514

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Adjusting Entries for Prepaid Expense

There are times in business when expense items are paid for in advance.

This presents no problem if the expense item falls entirely within the fiscal period .

If the expense item affects more than the current fiscal period, then it must be treated as a prepaid expenseprepaid expense.

A prepaid expenseprepaid expense is an item paid for in advance, but one where the benefits

extend into the future.

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Insurance is the most common prepaid expense.

A business can purchase insurance to cover possible losses on automobiles, buildings, contents, crops, etc.

When you purchase insurance, you usually pay for one year’s coverage in advance. ( Note: occasionally, the period can be greater than one year.)


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When prepaid expensesprepaid expenses are purchased, they are usually debited to a prepaid expense account.

Prepaid expensesPrepaid expenses accounts have value and are therefore classified as assets.

If, for example you were to cancel an insurance policy, all (or a portion) of the prepaid insurance expense would be refunded by the insurance broker /

company.


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2007 2007

600 600

1,200 600

Prepaid annual insurance premium on September 1, 2007.

600 600


$1,800 x 4/12

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Goods and services are often bought and received toward the end of an accounting period.

The invoices for these items may not arrive until the subsequent fiscal period.

The Matching Principle states that expenses are to be recognized in the same period as the revenue that they

help to earn.

Adjusting Entries for Late-Arriving Purchase Invoices

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The financial statements are not “typically” prepared until two or three weeks after the fiscal year end.

During this waiting period, the accounting department must analyze all purchase invoices in order to find those that affect the fiscal period that just ended.


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Prior to financial statement preparation, the accountant discovers there were two late-

arriving invoices: telephone $212 and utilities $315.


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Students should complete questions in section 9-1 and start questions and exercises section 9-2 in workbook

Class / Homework

Adjusting Entries and the Work Sheet

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The first place that adjusting entries are recorded is on the work sheet.

As the work sheet is prepared, adjusting entries are calculated and recorded in a section headed Adjustments.

Adjusting Entries and the Work Sheet

The physical inventoryof supplies at Dec. 31

totaled $526.What adjusting entry

is required?

Supplies Expense 954.901

954.901An analysis of prepaidinsurance determined

that the balance at Dec. 31 should

be $4,070.What adjusting entry

is required?

Insurance Expense 2494.002

2494.002

A clerk discoveredthree “late” purchaseinvoices belonging to2007…telephone $45,

truck repair $496 & printer repair $85.

45.003496.003

85.003

626.003

Balance the Adjustments Columns.Extending the Work Sheet … add or subtract the adjustments from the trial balance and record in the last four columns.

1

1

2

2

3

33

3

526.004,070.00

3,136.00

1

1

2

2

3

33

3

Balancing the Work Sheet … total each of the last four columns

1

1

2

2

3

33

3

Balancing the Work Sheet … determine the diff. between thetwo income statement columns the two balance sheet columns

1

1

2

2

3

33

3

Net Income

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So far, the adjusting entries have been recorded only on the work sheet

Once the work sheet is complete / balanced, the adjusting entries must be recorded in the books of accounts.

Journalize and post all entries that appear in the adjustments section of the work sheet.

Journalize Adjusting Entries

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Journalize Adjusting Entries

Class work and homework

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Students should complete up to end of section 9-2 questions and exercises

Closing Entries

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The Time Period Concept states that financial reporting, or net income in particular, is done in equal period of time.

After you do your adjusting entries and prepare your formal income statements, the accounts must be made ready for the next accounting cycle.

Closing Entries Concepts

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Determine which accounts have balances that continue from one period to the next and which do not.

There are two types of accounts … real accountsreal accounts and nominal accountsnominal accounts.

All asset and liability accounts, as well as the owner’s capital account, are considered to be real accountsreal accounts.


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Real accountsReal accounts have balances that continue into the next fiscal period.

Nominal accountsNominal accounts (revenue, expense and drawings accounts) have balances that do not continue into the next fiscal period.

Nominal accountsNominal accounts, with the exception of drawings, are related to the income statement.


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A special nominal account, called the Income Summary accountIncome Summary account, is used only during the closing entry process.

Once the income statement for a period has been completed, the balances in the nominal accounts are no longer useful … their balance must be taken to zero in preparation for the next accounting cycle.


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Closing an accountClosing an account means to cause it to have no balance.

Any changes in equity during the period are contained in the Revenue, Expense, and Drawings accounts.

Closing these nominal accounts moves the values collected in these accounts into the one real equity account, the Capital account.


Complete Accounting CycleTransactions occur.Source documents.

Accounting entriesrecorded in the journal.

Performeddaily

Ledger balanced bymeans of a trial balance.

Performedmonthly

Journal entries postedto the ledger accounts.

Performedby

accountingclerks

Formal income stmt. &balance sheet prepared.

Closing entriesjournalized & posted.

Adjusting entriesjournalized & posted.

Performedby

accountants

Work sheet prepared.

Post-closingtrial balance.

Performedat end of

each fiscalperiod

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p. 324, Exercises 1p. 326, Exercises 4

Class / Homework

Journalizing and Posting the

Closing Entries

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1

2

2

3

33

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Net Income

Closing Entry 1Closing Entry 1: transfer the balances in the revenue account(s) to a new nominal account called Income Summary.

Closing Entry 2Closing Entry 2: transfer the balances in the expense accounts to the Income Summary account.

Closing Entry 3Closing Entry 3: transfer the balances in Income Summary Account to the owner’s Capital account.

Closing Entry 4Closing Entry 4: transfer the balances in Drawings account to the owner’s Capital account.

Summary of Closing Entries

Post-Closing Trial Balance

Balance the Adjustments Columns.Extending the Work Sheet … add or subtract the adjustments from the trial balance and record in the last four columns.

1

1

2

2

3

33

3

526.004,070.00

3,136.00

1

1

2

2

3

33

3

Balancing the Work Sheet … total each of the last four columns

1

1

2

2

3

33

3

Post-Closing Trial Balance

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1

2

2

3

33

3

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Capital AccountCalculating your Post-Closing Balance

$28,895.42P. Marshall, Capital

66,836.09 3$42,000.004

$53,731.51

$42,000.00 $95,731.51

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Post-Closing Trial BalanceP. Marshall, Capital

$28,895.4266,836.09

$95,731.51

$53,731.81

$42,000.00

$42,000.00

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Students should complete section 9-3 questions and exercises

Class / Homework

Adjusting for Depreciation

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Assets that are used to produce revenue over several fiscal periods are known as fixed assetsfixed assets.

Fixed assets are also known as “long-lived assets”, “capital equipment”, and “plant and equipment”.

Except for land, all fixed assets will be used up in the course of time and activity.


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Fixed assets decrease or depreciate in value.

DepreciationDepreciation refers to an allowance made for the decrease in value of an asset over time.

It is not possible to calculate depreciation until the end of the asset’s life … only then, can you say

how many years it was used and determine its final worth.


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The matching principle dictates that depreciationdepreciation must be included on every year-end income statement.

To do this, accountants must estimate depreciation while the asset is still in use.

The two most common methods of calculating depreciation are the:

Straight-LineStraight-Line method and Declining-balanceDeclining-balance method.


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The simplest way to estimate depreciation.

The Straight-Line method of Straight-Line method of depreciationdepreciation divides up the net cost of the asset equally over the years of the asset’s life.

Straight-Line Depreciation

Straight-Line Depreciation for one year

=

Original Cost of Asset -

Estimated Salvage Value

Estimated Number of Periods in the Life of the Asset

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You purchased a truck for $78,000 on January 1, 2007. It is estimated that the truck will be used for six years, and at the end of that time, could be sold for $7,800. What is the annual depreciation?



=




=$78,000 - $7,800

6

= $11,700

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You purchased furniture for $5,120 on January 1, 2007. It is estimated that the furniture will be used for 10 years, and at the end of that time, could be sold for $500. What is the annual depreciation?



=




=$5,120 - $500

10

= $462

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When adjusting for depreciation you would expect to DR DR Depreciation Expense Depreciation Expense CR AssetCR Asset

In order to show the value of the Asset at cost, you would not CR CR AssetAsset for the depreciation … rather you CR CR Accumulated DepreciationAccumulated Depreciation.

Adjusting Depreciation

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Accumulated depreciation is a valuation or contra account.

A contra accountcontra account is one that is displayed alongside an associated account and has a balance that is opposite to the account it is associated with.

Accumulated depreciation is also known as a valuation accountvaluation account … an account that is used, together with an asset account, to

show the true net value (or net book value) of the asset.

Accumulated Depreciation

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In the truck example, the adjusting entry would be:DR Depreciation Expense 11,700 CR Accumulated Amortization 11,700

In the furniture example, the adjusting entry would be:DR Depreciation Expense 462 CR Accumulated Amortization 462

Adjusting Entry for Depreciation

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Income StatementDepreciation expense is shown on the income

statement.Each depreciation expense item is shown separately

(e.g. Depreciation Expense – Truck).

Balance SheetAccumulated depreciation is deducted from its

respective fixed asset account on the balance sheet.Each asset, with its related accumulated depreciation,

is shown separately. For example: Truck $78,000

Less: Accumulated Depreciation Depreciation 11,700 $66,300

Financial Statement Presentation

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Sometimes an asset is used for only part of a year.

For example, you purchase a building on May 1, 2007 for $120,000. The building is expected to be used for 30 years, after which it will be worth $30,000. Your company issued financial statements quarterly (i.e. every 3 months).Annual depreciation = (120,000 – 30,000) / 30

= $3,000Monthly depreciation = 3,000 / 12 = $250 per month

The depreciation expense would be 1st quarter $ 0 and

2nd quarter $500.

Depreciation for Part Year

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The declining-balance methoddeclining-balance method is an alternative to the straight-line method of calculating depreciation.

The declining-balance method is common because the government of Canada requires a variation of this method for income tax purposes.

This method calculates the annual depreciation by multiplying the remaining undepreciated cost (i.e. net book value)

by a fixed percentage.

Declining-Balance Depreciation

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Some of the percentage rates set by the government are as follows:


Canada Customs and Revenue AgencyCanada Customs and Revenue AgencyRates of Capital Cost Allowance (Depreciation)

Class Description Rate3 Buildings of brick, stone, or cement 5%6 Buildings of frame, lot, or stucco 10%8 Office furniture and equipment 20%

10 Automobiles, trucks, tractors, computer equipment 30%

12 Computer software (except system software) 100%

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Example: you purchase computers on January 1, 2006 for $22,000. The rate, per the previous slide, is 30%.

Depreciation expense would be calculated as follows:

2006: Original Cost $22,000 Less: Depreciation ($22,000 x 30%) 6,600

Undepreciated cost (net book value) $15,400


2007: Undepreciated Cost $15,400 Less: Depreciation ($15,400 x 30%) 4,620 Undepreciated cost (net book value) $10,780

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For straight-line, assume the computers have an 8 year life with an ending value of $2,000.

Comparison of the Two Methods of Depreciation

$22,000 - $2,0008

= $2,500 / year

The straight-line method produces

depreciation figuresthat are the same each year.

The net book value (NBV)or undepreciated cost

gradually reduces until it reaches the estimated

Salvage value.

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Comparison of the Two Methods of Depreciation

The declining- balance method

produces depreciationfigures that are the larger inthe early years and smaller

in the later years. Theestimated final value is

ignored using thismethod.

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Canada Customs and Revenue Agency (CCRA) requires businesses to use the declining-balance method when calculating depreciation for tax purposes.

In addition, the CCRA generally allows 50% of the asset’s cost to be eligible for depreciation in its first year of use … regardless of the month it was purchased.

The CCRA refers to this as the “50% Rule”

Tax Regulations

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How would the “50% Rule” look?

Tax Regulations

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p. 348, Exercise 1p. 349, Exercise 2 (do all the parts,

plus in part B, calculate with and without the “50% rule”)

p. 350, Exercise 3 … prepare the adjusting entries and an adjusted trial balance.

Class / Homework

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p. 361, Exercise 1Comprehensive Exercise

Documents

1 Chapter 9 Completing the Accounting Cycle Created by D. Gilroy Heart Lake Secondary School