COMPLETING THE ACCOUNTING CYCLE

1 4. COMPLETING THE. ACCOUNTING CYCLE . objectives After studying this chapter, you should be able to: 1 Review the seven basic steps of the ACCOUNTING CYCLE . 2 Prepare a work sheet. 3 Prepare financial statements from a work sheet. 4 Prepare the adjusting and closing entries from a work sheet. 5 Explain what is meant by the fiscal year and the natural business year. 6 Analyze and interpret the financial solvency of a business by computing working capital and the current ratio. PHOTO: CORBIS. M ost of us have had to file a personal tax return. At the beginning of the year, you estimate your upcoming income and decide whether you need to increase your payroll tax withholdings or perhaps pay estimated taxes. During the year, you earn income, make investments, and enter into other tax-related transactions, such as mak- ing charitable contributions.

2 At the end of the year, your employer sends you a tax withholding information form (W-2 form), and you collect the tax records needed for COMPLETING your yearly tax forms. If any tax is owed, you pay it; if you overpaid your taxes, you file for a refund. As the next year begins, you start the CYCLE all over again. Businesses also go through a CYCLE of activities. At the beginning of the CYCLE , man- agement plans where it wants the business to go and begins the necessary actions to achieve its operating goals. Throughout the CYCLE , which is normally one year, the accountant records the operating activities (transactions) of the business. At the end of the CYCLE , the accountant prepares financial statements that summarize the oper- ating activities for the year. The accountant then prepares the accounts for recording the operating activities in the next CYCLE .

3 As we saw in Chapter 1, the initial CYCLE for NetSolutions began with Chris Clark's investment in the business on November 1, 2005. The CYCLE continued with record- ing NetSolutions' transactions for November and December, as we discussed in Chap- ters 1 and 2. In Chapter 3, the CYCLE continued and we recorded the adjusting entries for the two months ending December 31, 2005. Now, in this chapter, we discuss the flow of the adjustment data into the accounts and into the financial statements. ACCOUNTING CYCLE The ACCOUNTING process that begins with analyzing and journalizing transactions and objective 1 ends with summarizing and reporting these transactions is called the ACCOUNTING Review the seven basic steps CYCLE . The most important output of this CYCLE is the financial statements. of the ACCOUNTING CYCLE . The basic steps of the ACCOUNTING CYCLE are shown, by number, in the flowchart in Exhibit 1.

4 In earlier chapters, we described and illustrated the analysis and record- In a computerized ACCOUNTING sys- ing of transactions, posting to the ledger, preparing a trial balance, ana- tem, the software automatically lyzing adjustment data, preparing adjusting entries, and preparing financial records and posts transactions. The ledger and supporting records statements. In this chapter, we complete our discussion of the ACCOUNTING are maintained in computerized CYCLE by describing how work sheets may be used as an aid in preparing master files. In addition, a work the financial statements. We also describe and illustrate how closing entries sheet is normally not prepared. and a post-closing trial balance are used in preparing the ACCOUNTING records for the next period. Work Sheet Accountants often use working papers for collecting and summarizing data they objective 2 need for preparing various analyses and reports.

5 Such working papers are useful Prepare a work sheet. tools, but they are not considered a part of the formal ACCOUNTING records. This is in contrast to the chart of accounts, the journal, and the ledger, which are essential parts of the ACCOUNTING system. Working papers are usually prepared by using a Common spread- spreadsheet program on a computer. sheet programs used The work sheet is a working paper that accountants can use to summarize ad- in business include justing entries and the account balances for the financial statements. In small com- Microsoft Excel and Lotus 1-2-3 . panies with few accounts and adjustments, a work sheet may not be necessary. For example, the financial statements for NetSolutions can be prepared directly from the adjusted trial balance illustrated in Chapter 3. In a computerized ACCOUNTING system, Chapter 4 COMPLETING the ACCOUNTING CYCLE 141.

6 Exhibit 1 ACCOUNTING CYCLE Accts. Rec. 112.. Cash 111.. Source Documents Journal Ledger . XYZ Co. XYZ Co. Work Sheet Post-Closing Trial Balance For the Period Ended December 31, 20 . December 31, 20 . Adjusted Trial Trial Income Balance Balance Adjustments Balance Statement Sheet Post-Closing Work Sheet Trial Balance (optional) .. Balance Sheet Transactions are analyzed and recorded in the journal. Statement of Transactions are posted to the ledger. Owner's Equity A trial balance is prepared, adjustment data are Income Statement assembled, and an optional work sheet is completed. Financial statements are prepared. Adjusting entries are journalized and posted to the ledger. Closing entries are journalized and posted to the ledger. A post-closing trial balance is prepared. Financial Statements a work sheet may not be necessary be- cause the software program automatically posts entries to the accounts and prepares The work sheet is a useful financial statements.

7 Device for understanding The work sheet (Exhibits 2 through 5. on pages 142 146) is a useful device for the flow of the ACCOUNTING understanding the flow of the ACCOUNTING data from the unadjusted data from the unadjusted trial balance to the financial statements (Exhibit 6). This trial balance to the financial flow of data is the same in either a man- statements. ual or a computerized ACCOUNTING system. Unadjusted Trial Balance Columns To begin the work sheet, list at the top the name of the business, the type of working paper (work sheet), and the period of time, as shown in Exhibit 2. Next, enter the unadjusted trial balance directly on the work sheet. The work sheet in Exhibit 2 shows the unadjusted trial balance for NetSolutions at December 31, 2005. 142 Chapter 4 COMPLETING the ACCOUNTING CYCLE Exhibit 2 Work Sheet with Unadjusted Trial Balance Entered NetSolutions Work Sheet For the Two Months Ended December 31, 2005.

8 Adjusted Income Trial Balance Adjustments Trial Balance Statement Balance Sheet Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. 1 Cash 2,065 1. 2 Accounts Receivable 2,220 2. 3 Supplies 2,000 3. 4 Prepaid Insurance 2,400 4. 5 Land 20,000 The work sheet is used for sum- 5. 6 Office Equipment 1,800 marizing the effects of adjusting 6. 7 Accounts Payable 900 entries. It also aids in preparing 7. 8 Unearned Rent 360 financial statements. 8. 9 Chris Clark, Capital 25,000 9. 10 Chris Clark, Drawing 4,000 10. 11 Fees Earned 16,340 11. 12 Wages Expense 4,275 12. 13 Rent Expense 1,600 13. 14 Utilities Expense 985 14. 15 Supplies Expense 800 15. 16 Miscellaneous Expense 455 16. 17 42,600 42,600 17. 18 18. Adjustments Columns The adjustments that we explained and illustrated for NetSolutions in Chapter 3 are entered in the Adjustments columns, as shown in Exhibit 3.

9 Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing the work sheet. It is also helpful for identifying the adjusting entries that need to be recorded in the journal. The order in which the adjustments are entered on the work sheet is not im- portant. Most accountants enter the adjustments in the order in which the data are assembled. If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should be inserted in the Account Title column, below the trial balance totals, as needed. To review, the entries in the Adjustments columns of the work sheet are: (a) Supplies. The supplies account has a debit balance of $2,000. The cost of the supplies on hand at the end of the period is $760. Therefore, the supplies expense for December is the difference between the two amounts, or $1,240.

10 Enter the adjustment by writing (1) $1,240 in the Adjustments Debit column on the same line as Supplies Expense and (2) $1,240 in the Adjustments Credit column on the same line as Supplies. (b) Prepaid Insurance. The prepaid insurance account has a debit balance of $2,400, which represents the prepayment of insurance for 24 months beginning December 1. Thus, the insurance expense for December is $100 ($2,400/24). Enter the adjustment by writing (1) $100 in the Adjustments Debit column on Chapter 4 COMPLETING the ACCOUNTING CYCLE 143. the same line as Insurance Expense and (2) $100 in the Adjustments Credit column on the same line as Prepaid Insurance. (c) Unearned Rent. The unearned rent account has a credit balance of $360, which represents the receipt of three months' rent, beginning with December. Thus, the rent revenue for December is $120.