CTB-6008 Session 3 Accounting Cycle PDF

CTB-6008 SESSION 3 Alexandrine Baril, CPA, MBA, M.Fisc. © 2020 McGraw-Hill Limited 4-1  ACCOUNTING CYCLE © 20...

CTB-6008 SESSION 3 Alexandrine Baril, CPA, MBA, M.Fisc. © 2020 McGraw-Hill Limited 4-1  ACCOUNTING CYCLE © 2020 McGraw-Hill Limited 4-2  ACCOUNTING CYCLE © 2020 McGraw-Hill Limited 4-3  ACCOUNTING CYCLE Accounting cycle = the process used by entities to: Analyze and record transactions Adjust the records to provide reliable account balances at the end of the period Prepare the financial statements Prepare the records for the next cycle During the accounting period → transactions that result in exchanges of benefits and obligations between the company and other external parties are analyzed and recorded in the General Journal in chronological order (journal entries), and the related accounts are updated in the General Ledger End-of-period steps → focus primarily on adjustments to record revenues and expenses in the proper period and to update the statement of financial position accounts for reporting purposes © 2020 McGraw-Hill Limited 4-4  ADJUSTING JOURNAL ENTRIES © 2020 McGraw-Hill Limited 4-5  ADJUSTING JOURNAL ENTRIES 1. When events occur, we compute journal entries to record the transactions… 2. As time goes by, through the consumption of goods or changes in some situations, we realize that our initial journal entries might not be accurate anymore 3. Especially at the end of the financial period, some adjusting journal entries must be recorded to illustrate these changes in various accounts © 2020 McGraw-Hill Limited 4-6  PURPOSE OF ADJUSTMENTS Adjusting journal entries = are recorded at the end of every accounting period, so that: Revenues → are recorded when earned (revenue recognition principle) Expenses → are recorded when incurred to generate revenue during the same period (matching process) Assets → are reported at amounts that represent the probable future benefits remaining at the end of the period Liabilities → are reported at amounts that represent the probable future sacrifices of assets or services owed at the end of the period © 2020 McGraw-Hill Limited 4-7  ADJUSTING JOURNAL ENTRIES When do we compute adjusting entries? Companies wait until the end of the accounting period to adjust their accounts, because adjusting the records daily would be very costly and time-consuming… Adjusting entries are minimally required every time a company wants to prepare financial statements for external users © 2020 McGraw-Hill Limited 4-8  Adjustments Prepaid 1 2 3 Unearned 4 Accrued 5 Accrued Amortization Expenses Revenues Expenses Revenues These are the 5 types of accounts for which some adjusting journal entries must be recorded! Note : Amortization is different, so it will be covered in another module © 2020 McGraw-Hill Limited 4-9  Adjustments Prepaid 1 2 Unearned 3 Accrued 4 Accrued Amortization Expenses Revenues Expenses Revenues 1. At time of initial recording → we recorded an asset or a liability 2. Time or economic events have influenced these assets or liabilities… 3. Adjustment needs to be made to take these changes into account! © 2020 McGraw-Hill Limited 4-10  1) PREPAID EXPENSES = Costs paid in cash and recorded as assets before they are used We paid for these expenses in advance, and will benefit from them in a near future These costs expire with the passing of time or through the use and consumption (Ex. insurance, supplies) © 2020 McGraw-Hill Limited 4-11  PREPAID EXPENSES — EXAMPLE On January 1st, a company purchases an insurance policy that covers 3 months and costs $ 1,800. The entry to record the purchase of the insurance policy would be: Prepaid Insurance (Asset) $ 1,800 Cash $ 1,800 The adjusting entry to record the expiry of the insurance for January would be (idem for February and March): Insurance Expense $ 600 Prepaid Insurance $ 600 © 2020 McGraw-Hill Limited 4-12  SUPPLIES – EXAMPLE The entry to record the purchase of $ 1,500 of office supplies would be (record as an asset when paid): Supplies (Asset) $ 1,500 Cash $ 1,500 By counting the supplies on September 30, the company determined that $ 350 were on hand. The adjusting entry would be: Supplies Expense $ 1,150 Supplies $ 1,150 © 2020 McGraw-Hill Limited 4-13  2) UNEARNED REVENUES = Cash received in advance of providing products and services The company has an obligation to provide the goods or offer the services Unearned revenues → they are liabilities representing the company’s promise to perform or deliver the goods or services in the future When a customer pays for goods or services before the company delivers them, the company records the amount of cash received in a deferred revenue account Recognition of (recording) the revenue is deferred (postponed) until the company meets its obligation © 2020 McGraw-Hill Limited 4-14  UNEARNED REVENUES — EXAMPLE On March 1st, a company received a $ 12,000 payment from a customer for maintenance services to be provided over the next 2 months. The entry to record the receipt of cash would be (record as liabilities when received): Cash $ 12,000 Unearned Revenue (Liab.) $ 12,000 On March 31st, $ 6,000 of these revenues have been earned. The adjusting entry to record the earned revenue would be: Unearned Revenue $ 6,000 Maintenance Revenue $ 6,000 © 2020 McGraw-Hill Limited 4-15  Adjustments Prepaid Unearned Accrued Accrued Amortization Expenses Revenues Expenses Revenues 1. Expenses and revenues that have not led to recording of an asset or a liability during the fiscal period 2. End of period adjustments are necessary to: Record the expense and the liability at the same time Record the revenue and the asset at the © 2020 McGraw-Hill Limited 4-16  3)ACCRUED EXPENSES = Costs incurred in a period that are both unpaid and unrecorded Numerous expenses are incurred in the current period without being paid for until the next period Common examples include interest expense incurred on debt, wages expense for the wages owed to employees, and utilities expense for water, gas, and electricity used during the period for which the company has not yet received a bill These accrued expenses accumulate (accrue) over time but are not recognized until the end of the period in an adjusting entry. Adjusting entries must be made to record the expense for the period and the related liability at the balance sheet date © 2020 McGraw-Hill Limited 4-17  ACCRUED INTEREST EXPENSES — EXAMPLE We signed a year $ 15,000 note payable on January 1st. The note bears interest at an annual rate of 8 % and is due on December 31st. The period ends on September 30th. Initial journal entry will be: Cash $ 15,000 Note Payable $ 15,000 © 2020 McGraw-Hill Limited 4-18  ACCRUED INTEREST EXPENSES — EXAMPLE The adjusting entry on September 30th, to record the accrued interest, would be: = 8% x $ 15,000 x 9 / 12 months (Jan. to Sept.) = $ 900 Interest Expense $ 900 Interest Payable $ 900 © 2020 McGraw-Hill Limited 4-19  ACCRUED SALARIES EXPENSE – EXAMPLE Assume that the employees receive total salaries of $ 2,500 for a five-day (Monday to Friday) work week, or $ 500 a day Assume that the financial year ends on September 30th Salaries were last paid on September 25th (for period of September 9th to September 22nd) and the next payment of salaries will be on October 11th (for period of September 23rd to October 5th) Since the financial year ends on September 30th → 6 days of work have not been paid at that date!!! © 2020 McGraw-Hill Limited 4-20  ACCRUED SALARIES EXPENSES — EXAMPLE The September 30th adjusting journal entry to record the accrued salaries would be: Salaries Expense $ 3,000 Salaries Payable $ 3,000 © 2020 McGraw-Hill Limited 4-21  4) ACCRUED REVENUES = Revenues earned in a period that are both unrecorded and not yet received in cash Sometimes, companies perform services or provide goods (i.e., earn revenue) before customers pay Because the cash that is owed for these goods has not yet been received, the revenue that was earned has not been recorded Revenues that have been recognized (earned) but have not yet been realized in cash and recorded at the end of the accounting period are called accrued revenues Adjusting entries must be made to record the revenue for the period and the related asset at the balance sheet date Examples: fees earned, interest earned, rent earned © 2020 McGraw-Hill Limited 4-22  ACCRUED REVENUES — EXAMPLE On December 31st, $ 16,500 of consulting fees have been earned but have not been recorded or billed to the client The entry to record the accrued consulting fees earned would be: Accounts Receivable $ 16,500 Consulting Fees Earned $ 16,500 © 2020 McGraw-Hill Limited 4-23  LET’S PRACTICE COMPUTING ADJUSTING JOURNAL ENTRIES! You have 25 minutes to complete the following exercise on the portal: « Lee Management Consulting » © 2020 McGraw-Hill Limited 4-24  PROPERTY, PLANT AND EQUIPMENT © 2020 McGraw-Hill Limited 4-25  PROPERTY, PLANT, AND EQUIPMENT (PPE) Property, plant, and equipment are assets that we acquire to use on a long-term basis, and that will eventually be sold or disposed of when we don’t need them anymore In other words, these assets are also used over time to generate revenue → Thus, a part of their cost should be expensed in the same period (to respect the the matching process) These assets depreciate over time as they are used In accounting, depreciation is an allocation of an asset’s cost over its estimated useful life to the organization © 2020 McGraw-Hill Limited 4-26  PROPERTY, PLANT, AND EQUIPMENT (PPE) To keep track of the asset’s historical cost, the amount that has been used is not subtracted directly from the asset account. Instead, it is accumulated in a new kind of account called a ‘contra account’ A contra account = an account that is an offset to, or reduction of, the primary account It is directly related to another account but has a balance on the opposite side As a contra account increases, the net amount (the account balance less the contra-account balance) decreases For property, plant, and equipment, the contra account is called Accumulated depreciation © 2020 McGraw-Hill Limited 4-27  PROPERTY, PLANT, AND EQUIPMENT (PPE) Since assets have debit balances, accumulated depreciation has a credit balance On the statement of financial position (balance sheet), the amount that is reported for property, plant, and equipment is its net book value Net book value = ending balance in the PPE account minus ending balance in the Accumulated depreciation account © 2020 McGraw-Hill Limited 4-28  CLOSING JOURNAL ENTRIES © 2020 McGraw-Hill Limited 4-29  CLOSING THE BOOKS: END OF THE ACCOUNTING CYCLE Statement of financial position (Balance sheet) accounts are permanent (real) accounts and are not reduced to zero at the end of the accounting period. The ending balance for the current accounting period becomes the beginning account balance for the next accounting period However, revenues, expenses, gains, losses, and dividends accounts are used to accumulate transaction effects for the current accounting period only; they are called temporary (nominal) accounts At the end of each period, the balances in the temporary accounts are transferred, or closed, to the retained earnings account by recording closing entries © 2020 McGraw-Hill Limited 4-30  CLOSING ENTRIES  The closing entries have two purposes: 1. To transfer the balances in the temporary accounts to retained earnings 2. To establish a zero balance in each of the temporary accounts to start the accumulation in the next accounting period © 2020 McGraw-Hill Limited 4-31  STEPS FOR CLOSING ENTRIES Prepare an entry to close the Revenues and Gains accounts, which have credit balances and are closed by debiting the total amount to Income Summary Prepare an entry to close the expenses and losses accounts, which have debit balances and are closed by crediting the total amount to Income Summary account Prepare an entry to close the dividends declared account to the Retained Earnings account The balance of the Income Summary account reflects the net earnings (or loss) and is then closed to the Retained Earnings account © 2020 McGraw-Hill Limited 4-32  POST-CLOSING TRIAL BALANCE After all temporary accounts have been closed, we prepare a post-closing trial balance Only assets, liabilities, and shareholders’ equity accounts will appear All revenue, expense, gain and loss accounts will have a zero balance and debits should equal credits © 2020 McGraw-Hill Limited 4-33  RATIOS © 2020 McGraw-Hill Limited 4-34  EARNINGS PER SHARE (EPS) The actual calculation for EPS is quite complex and appropriate for intermediate accounting courses; however, in this text we simplify the earnings per share calculation to be: © 2020 McGraw-Hill Limited 4-35  STATEMENT OF CHANGES IN EQUITY The final amount from the statement of earnings, net earnings, is carried forward to the retained earnings column of the statement of changes in equity Net earnings is an increase in Retained Earnings Dividends declared during the period are deducted to arrive at the ending balance The issuance of additional shares is added to the beginning balance of contributed capital © 2020 McGraw-Hill Limited 4-36  STATEMENT OF FINANCIAL POSITION (BALANCE SHEET) The ending balances under the contributed capital, retained earnings, and other components headings of the statement of changes in equity are included on the statement of financial position. Assets are listed in order of liquidity, while liabilities are listed in order of time to maturity. Current assets are those used or turned into cash within one year. Current liabilities are obligations to be settled within one year. © 2020 McGraw-Hill Limited 4-37  NET PROFIT MARGIN RATIO  The net profit margin ratio compares net earnings to the revenues generated during the period ANALYTICAL QUESTION → How effective is management at controlling revenues and expenses to generate more earnings? RATIO AND COMPARISONS → The net profit margin ratio is useful in answering this question. It is computed as follows: Net Profit Net Earnings Margin Ratio= Net Sales (or Operating revenues)* *Net sales is sales revenue less any returns from customers, and other reductions. For companies in the service industry, total operating revenues equals net sales © 2020 McGraw-Hill Limited 4-38  NET PROFIT MARGIN RATIO INTERPRETATIONS The net profit ratio margin measures how much profit is earned as a percentage of revenues generated during the period. A rising net profit margin ratio signals more efficient management of sales and expenses. Financial analysts expect well-run businesses to maintain or improve their net profit margin ratio over time. © 2020 McGraw-Hill Limited 4-39  RETURN ON EQUITY (ROE)  The return on equity relates net earnings to shareholders’ investment in the business. ANALYTICAL QUESTION → How well has management used shareholder investment to generate net earnings during the period? RATIO AND COMPARISONS → The return on equity (ROE) helps in answering this question. It is computed as follows: ​ Net Earnings Return on = Equity Average Shareholders’ Equity* *Average shareholders’ equity = (Beginning shareholders’ equity + Ending shareholders’ equity) ÷ 2 © 2020 McGraw-Hill Limited 4-40  RETURN ON EQUITY INTERPRETATIONS ROE measures how much the firm earned as a percentage of shareholders’ investment. In the long run, firms with higher ROE are expected to have higher share prices than firms with lower ROE, all other things being equal. Managers, analysts, and creditors use this ratio to assess the effectiveness of the company’s overall business strategy (its operating, investing, and financing strategies). © 2020 McGraw-Hill Limited 4-41