ACCOUNTING ~ Is the recording of financial transactions of a business or organization, It also includes the process of summarizing, analyzing and reporting these transactions in financial statements. ACCOUNTING CYCLE ~ is a step-by-step process of recording, classification and summarization of economic transactions of a business. It generates useful financial information in the form of financial statements including statement of financial performance, statement of balance sheet, cash flow statement and statement of changes in equity. = the time petiod principles requires that a business should prepare its financial statement on periodic basis. Therefore accounting cydle is followed once during each accounting period. Accounting cycle starts from the recording of individual transactions and ends on the preparation of financial statement and closing entries. MAJOR STEPS IN ACCOUNTING CYCLE = The following are the major steps involved in the accounting cycle, we will use a simple example to explain each step: 1. Analyzing and recording transactions via journal entries; 2. Posting journal entries to ledger accounts; 3. Preparing unadjusted trial balance; 4. Preparing adjusting entries at the end of the ‘period; 5. Preparing adjusted trial balance; 6. Preparing financial statements; 7. Closing temporary accounts via closing entries; and 8. Preparing post-closing trial balance. 1. Journal Entries ~ Analyzing transactions and recording them as journal entries isthe first step in the accounting cyde. Tt begins at the start of an accounting period and continues during the whole period. Transaction analysis is a process which determines whether a particular business event has an economic effect on the assets, liabilities or equity of the business. It also involves ascertaining the magnitude of the transaction ie, its currency value. = After analyzing transactions, accountants classify and record the events having economic effect via Journal entries according to debit-credit rules. Frequent journal entries are usually recorded in specialized Journals, for example, sales journal and purchases journal. The rest are recorded in a general journal. The following exemple illustrates how to record journal entries: Example Mr. Handsome started his business on January 1, 2016 with an initial capital of P500,000.00. During the first month of operation, Mr. Handsome engaged in following transactions: Date Transaction Jan 02 An amount of 36,000 was paid as advance rent for three months, Jan 03 Paid 60,000 cash on the purchase of equipment. Jan 04 Purchased office supplies costing 17,600 on account. Jan 12 Bought merchandise P40,000.00 cash as per CV # 104 Jan 12 Purchased merchandise from Kulapipit on account, 29,500.00 terms 2/15; n/30 per invoice #767 Jan 13 Paid the accounts payable on the office supplies purchased on January 4, Jan 13. Retumed defective merchandise to Kulapipit worth 500 debit memo #7 was received to this effect Jan 14 Paid wages to its employees for first two weeks of January, aggregating 19,100. Jan 18 Sold merchandise to Ms, Tina Pah as per charge invoice #301 P50,000 terms 2/10; n/15. Jan 23 Miss Tina Pah returned defective merchandise P1,200.00 and a credit memo #1 was issued to this effect. Jan 25 Paid the account to Kulapipit in full dated January 12 as per CV # 108 Jan 26 Purchased office supplies costing 5,200 on account. Jan 28 Paid wages to its employees for the third and fourth week of January: 19,100. Jan 28 Received cash from Ms. Tina Pah in full settlement of her account dated Jan 18, offical receipts #02 was issued Jan 31 Received electricity bill of 2,470. Jan 31 Received telephone bill of 1,494. Jan 31 Miscellaneous expenses paid during the month totaled 3,470 Jan 31 Mr. Handsome withdrew 10,000 cash for personal useMr. Handsome uses the following account tities in recording the above transactions: ‘Account Code ‘Account Titles UL ‘Cash rT ‘Merchandising Inventory 2 ‘Account Receivable. 134 Prepaid Rent a4 Office Supplies 151 Equipment 161 ‘Accumulated Depreciation - Equipment 2it ‘Account Payable 228 Utilities payable 31 ‘Me. Handsome, Capital 3a ‘Mr. Handsome, Drawings 10 ‘Sales ait ‘Sales discount 412 ‘Sales return and allowance 510, Purchase Sit Purchase return and allowance: 52, ‘Purchase discount 520, ‘Salaries Expense 530, ‘Office Supplies Expense: 540. Electricity Expense 550. “Telephone Expense: 560. Rent Bepense 570. ‘Depreciation Expense 580, ‘Miscellaneous Expense 600 ‘Income and expense summary ‘The following table shows the journal entries for the above events, assuming Mr. Handsome uses periodic inventory system in recording merchandise account. Date. ‘Account Debit. Credit Jan (Cash 500,000 Mr, Handsome Capital 500,000 Jan2 Prepaid Rent 36,000 Cash 36,000 Jan 3 Equipment 160,000 Cash 160,000 Jan 4 Office Supplies 17,600 ‘Accounts Payable 17,600 Jan 12 Purchases 40,000 Gash 40,000 Jan 12 Purchases 29,500 ‘Accounts Payable 29,500 Jan 13 ‘Accounts Payable 47,600 Cash 417,600 Jan 13 Accounts Payable 500 Purchase retum & allowance 500 Jan 14 Salaries Expense 19,100 Cash 19,100 Jan 18 ‘Accounts Receivable 50,000 Sales 50,000 Jan 23 Sales return and allowance 4,200 ‘Accounts Receivable 1,200 Jan 25 ‘Accounts payable 29,000 Purchase discount 580 Gash 28,420 Jan 26 Office Supplies 5,200 ‘Accounts Payable 5,200 Jan 28 Salaries Expense 19,100 Cash 19,100 Jan 28 ash 49,000 Sales discount 41,000 ‘Accounts Receivable 49,000 san 31 Hlectricty Expense 2,470 Utlities Payable 2,470 Jan 31 ‘Telephone Expense 1494 Uslities Payable 1494 Jan 31 Miscellaneous Expense 3470 Cash 3,470 Jan 31 Mr. Handsome Drawings 410,000 Gsh 10,0002, Posting Journal Entries to Ledger Accounts ‘The second step of accounting cycle is to post the journal entries to the ledger accounts. ‘The journal entries recorded during the first step provide information about which accounts are to be debited and which to be credited and also the magnitude of the debit or credit (see debit-credit-rules). The debit and credit values of journal entries are transferred to ledger accounts one by one in such a way that debit amount of a journal entry is transferred to the debit side of the relevant ledger account and the credit, ‘amount is transferred to the credit side of the relevant ledger account. ‘After posting all the journal entries, the balance of each account is calculated. The balance of an asset, expense, contra-liability and contra-equity account is calculated by subtracting the sum of its credit side from the sum of its debit side. The balance of a liability, equity and contra-asset account is calculated the ‘opposite way i.e. by subtracting the sum of its debit side from the sum of its credit side. ‘The ledger accounts shown below are derived from the journal entries of Mr. Handsome. Asset Accounts ‘Acct Tite: Cash Aot#: LL Debit Credit Balance "500,000 '500,000, 36,000 464,000 {60,000 404,000, 40,000 364,000, 17,600 346,400. 19,100 327,300 28,420 298,880 19,100 279,780, 47,824 327,604 3,470 324,134 10,000 314,134 Prepaid ‘AcctTitie: Rent ‘AcctTitle: Office Supplies Acct #: 131 Acct #: 1a Date Debit Credit Balance, Date Debit ‘Credit Balance Jan. 02 36,000 36,000 Jan. 04 17,600, 17,600 Jan. 31 12,000 24,000 Jan. 26 5,200 22,800 Jan. 31 18,480, 4,320 ‘Acct Tite: Equipment ‘AcctTitle: Accumulated Depreciation ~ Equip. Acct #: 181 Acct #: 161 Date Debit Credit Balance, Date Debit Credit Balance Jan. 03 60,000 60,000) Jan. 31 1,000. 1,000) ‘AcctTitle: Utilities Payable Acct#: 221 Credit Balance Date’ Debit Credit Balance 17,600 17,600 Jon. 31 2,470 2,470 29,500 47,100 Jon. 31 1,494 3,964 Jan. 13 17,600 29,500 Jan. 13. 500) 29,000. Jan. 25, 23,000. 0 “en. 25 5,200 5,200Equity and Drawings Accounts: ‘AcctTite: Mr. Handsome, Capital Acct Title: Mr. Handsome, Drawings Act#: 31h Acct #321 Date Debit Gedit Balance Date Debit Gredit | ~Belance Jan. OL 500,000 | 500,000 Jan. 31 10,000 10,000, Jan. 31 | 10,600 Jan. 31 Revenue and Expense Accounts ‘Acct Title: Sales ‘Acct Title: Sales return & allowance 410 Acct #: 411 Debit Credit Balance, Date Debit Credit Balance 50,000 50,000 | |“ Jan. 23 1,200. 1,200 Jan. 31 Sales discount Acct Title: Purchases 410 Acct #: 510 Debit ‘Credit Balance, Date Debit ‘Credit Balance ‘76 ‘976 | | Jan. 12 40,000. 40,000 ‘Jan. 12 29,500, 69,500, an. 31 - Purchase ret. & allowances ‘Acct Tite: Purchase discount Sil Acct it: 512 Debit Gedit Balance, Date. Debit Credit Balance 500, S00} [“Jan. 25, Ea 580 =) (an. 3 a Office Supplies Expense Acct Title: Etectricity Expense 530 Acct #: | 540 Debit Great Balance, Date. Debit ‘Gedit Balance 18,480, 18480 | | Jan, 31 2470 2,470 15,480 =} (an. 31 2470 = Acct Tite: Telephone Expense Acct Title: Rent Expenses Act #: 550 Acct #: 560 Date Debit Gedit Balance, Date. Debit Credit Balance Jan. 37 1494 4494) | Jan. 32 12,000 12,000 ‘Jan. 31 1454, =| (an. 31 12,000 = Rect Depreciation Expense Tite: Miscellaneous Expense 570 Acct #: 580 Date. Debit Credit Balance] [7 Date Debt Credit Balance, Jan. 31 1,000. 3,000] | “Jan. 3 3470 3,470, Jan, 31 1,000. =} (Can. 3t 3400 = ‘Acct Title: Salaries Expense Acct #: 520 Date Debit Credit Balance Jan. 14 19,100 19,100 Jen. 28 19,300 38,200 Jan. 31 38,200, 5 “The ledger accounts step of accounting cycle completes here. The next step is the preparation of unadjusted trial balance.3. Unadjusted Trial Balance A trial balance is a list of the balances of ledger accounts of a business at a specific point of time usually at the end of a period such as month, quarter or year. ‘An unadjusted trial balance is the one which is created before any adjustments are made in the ledger accounts. ‘The preparation of a trial balance is very simple. All we have to do is to list the balances of the ledger accounts of a business. Example: Following is the unadjusted trial balance prepared from the ledger accounts of Mr. Handsome. Mr, HANDSOME UNADJUSTED TRIAL BALANCE January 31, 2016 ‘Account Titles Debit Credit Cash 314,134.00 Office Supplies 22,800.00 Prepaid Rent 36,000.00 | Equipment 60,000.00) ‘Accounts Payable: 5,200.00 Utilities Payable 3,964.00 Mr. Handsome, Capital ‘500,000.00 ‘Mr. Handsome, Drawings 10,000.00 Sales 50,000.00 Sales Return and Allowance 7,200.00 Sales Discount 976.00 Purchases 69,500.00 Purchase Return and Allowance 500.00 Purchase Discount 580,00, Salaries Expense 38,200.00 Electricity Expense 2,470.00 “Telephone Expense 1,494.00 Miscellaneous Expense 3,470.00 Total 560,244.00 | __560,244,00 Since, in double entry accounting we record each transaction with two aspects, therefore the total of debit and credit balances of the trial belance are always equal. Any difference shall indicate some mistake in the recording process or in the calculations. Although each unbalanced trial balance indicates mistake, but this does not mean that all errors cause the trial balance to unbalance. There are few types of mistakes which will not unbalance the trial balance and they may escape un-noticed if we do not review our work carefully. For example, to omit an entry, to record a transaction twice, etc. After the preparation of an unadjusted trial balance, adjusting entries are passed.4. Adjusting Entries ‘Adjusting entries are journal entries recorded at the end of an accounting period to adjust income and expense accounts so that they comply with the accrual concept of accounting. Their main purpose Is to match incomes and expenses to appropriate accounting periods, ‘The transactions which are recorded using adjusting entries are not spontaneous but are spread over a Period of time. Not all journal entries recorded at the end of an accounting period are adjusting entries. For example, an entry to record a purchase on the last day of a period Is not an adjusting entry. AN adjusting entry always involves either income or expense account. Types of adjusting entries: 1. Accruals: ‘These include revenues not yet received nor recorded and expenses not yet paid nor recorded. For ‘example, interest expense on loan accrued in the current period but not yet paid. 2. Prepayments: ‘These are revenues received in advance and recorded as liabilities, to be recorded as revenue and expenses paid in advance and recorded as assets, to be recorded as expense. For example, adjustments to unearned revenue, prepaid insurance, office supplies, prepaid rent, etc. 3. Non-cash: “These adjusting entries record non-cash items such as depreciation expense, allowance for doubtful debts etc. Example: ‘This example is a continuation of the accounting cycle problem we have been working on. In the previous ‘step we prepared an unadjusted trial balance. Here we will pass adjusting entries. Relevant information for the preparation of adjusting entries of Mr. Handsome 1. Office supplies having original cost 4,320 were unused till the end of the period. Office supplies having original cost of 22,800 are shown on unadjusted trial balance, 2. Prepaid rent of 36,000 was paid for the months January, February and March. 3. The equipment costing 60,000 has useful life of 5 years and its estimated salvage value is 0. Depreciation is provided using the straight line depreciation method. 4. At the end of the month, there are P29,000 worth of merchandises on hand. ‘The adjusting entries of Mr. Handsome are: Date Account. Debit Credit Jan 31 Office Supplies Expense 18,480 Office Supplies 18,480 ‘Supplies Expense = 22,800 - 4,320 Jan 31 Rent Expense 12,000 Prepaid Rent 12,000 Rent Expense = 36,000 = 3 = 12,000 Jan 31 Depreciation Expense 1,000 ‘Accumulated Depreciation - Equipment 1,000 Depreciation Expense = 60,000 + (5 x 12) = 1,100 Jan 31 Merchandising Inventory 29,000 Income and Expense Summary 29,000 ‘An adjusted trial balance is prepared in the next step of accounting cyele.5, Adjusted Trial Balance ‘An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after the preparation of adiusting entries. Adjusted trial balance contains balances of revenues and expenses along with those of assets, liabilities and equities. Adjusted trial balance can be used directly in the preparation of the statement of changes in stockholders’ equity, income statement and the balance sheet. However it does ‘not provide enough information for the preparation of the statement of cash flows. ‘The format of an adjusted trial balance is same as that of unadiusted trial balance. ‘The following adjusted trial balance was prepared after posting the adiusting entries of Mr Handsome to its general ledger and calculating new account balances: ‘Mr. HANDSOME ‘ADJUSTED TRIAL BALANCE. January 31, 2016 ‘Account Titles Debit Credit Cash 314,134.00 Merchandising Inventory 29,000.00 (Office Supplies 4,320.00 Prepaid Rent 24,000.00 Equipment 60,000.00, ‘Accumulated Depreciation - Equipment 1,000.00 ‘Accounts Payable 5,200.00 Utilities Payable 3,964.00 Mr. Handsome, Capital 500,000.00 Mr. Handsome, Drawings 10,000.00 Sales 50,000.00, Sales Retum and Allowance 1,200.00 Sales Discount 976.00 Purchases 68,500.00 Purchase Return and Allowance 500.00 Purchase Discount 580.00 Salaries Expense 38,200 Office Supplies Expense 16,480.00 Electricity Expense 2,470.00 “Telephone Expense 1,494.00 Rent Expenses. 12,000.00 Depreciation Expense 1,000.00 Miscellaneous Expense 3,470.00 Income and Expense Summary 29,000.00 Total — 520,244.00 | __590,244.09 ‘The totals of an adjusted trial balance must be equal. Any difference indicates that there is some error in ‘the journal entries or in the ledger or in the calculations. The next step of accounting cycle is the preparation of closing entries.6, Closing Entries Closing entries are journal entries made at the end of an accounting period which transfer the balances of temporary accounts to permanent accounts. Closing entries are based on the account balances in an adjusted trial balance. ‘Temporary accounts include: ‘+ Revenue, Income and Gain Accounts © Expense and Loss Accounts ‘+ Dividend, Drawings or Withdrawals Accounts + Tncome Summary Account ‘The permanent account to which balances are transferred depend upon the type of business. In case of a company, retained earnings account, and in case of a firm or a sole proprietorship, owner's capital account receives the balances of temporary accounts. Income summary account is a temporary account which facilitates the closing process. ‘Closing entries are better explained via an example. ‘The following example shows the closing entries based on the adjusted trial balance of Mr. Handsome Date ‘Account Title Debit Credit SivJan Sales 50,000 Sales Retum and Allowance 1,200 Sales Discount 976 Income and Expense Summary 47,824 3iJan Income and Expense Summary 145,534 Purchase Return and Allowance 500 Purchase Discount 580 Purchases 69,500 Salaries Expense 38,200 ‘Supplies Expense 18,480 Rent Expense 12,000 Miscellaneous Expense 3,470 Electricity Expense 2,470 ‘Telephone Expense 1,494 Depreciation Expense 1,000 3i-Jan Mr, Handsome, Capital 68,710 Income and Expense Summary 68,710 3i-Jan Mr. Handsome, Capital 10,000 Mr. Handsome, Drawings 10,0007. Post-Closing Trial Balance ‘The last step of an accounting cycle is to prepare post-closing trial balance ‘A post-closing trial balance isa list of balances of ledger accounts prepared after closing entries have been passed and posted to the ledger accounts. Since the closing entries transfer the balances of temporary accounts (Ie. expense, revenue, gain, dividend and withdrawal accounts) to the retained earnings account, the new balances of temporary accounts are zero and therefore they are not listed on a post-closing trial balance. However, all the other accounts having non-negative balances are listed including the retained earnings account. ‘The preparation of post-closing trial balance is the last step of the accounting cycle and its purpose is to be sure that sum of debits equal the sum of credits before the start of new accounting period. Tt provides the openings balances for the ledger accounts of the new accounting period. “The following post-closing trial balance was prepared after posting the closing entries of Mr. Handsome to Its general ledger and calculating new account balances: Mr. HANDSOME POST CLOSING TRIAL BALANCE January 31, 2016 ‘Account Tiles Debit Credit Gash 314,134.00 Merchandise Inventory. 29,000.00, Office Supplies 4,320.00, Prepaid Rent 24,000.00 Equipment. 60,000.00 Accumulated Depreciation - Equipment. 1,000.00 Accounts Payable 5,200.00. {Utilities Payable 3,964.00 [Mr. Handsome, Capital 421,290.00 Total 431,454.00 | __431.454.00 ‘This is the end of the accounting cycle. In the next accounting period, the accounting cycle will be repeated ‘again starting from the preparation of journal entries i. the first step of accounting cycle. 8. Financial Statements AA set of financial statements is a structured representation of the financial performance and financial position of @ business and how its financial position changed over time. It is the ultimate output of an ‘accounting information system and has following six components: Financial statements are better understood in context of all other components of the financial statements, For example a balance sheet will communicate more information if we have the related income statement, and the statement of cash flows too. Following the time-period principle, financial statements are prepared after a specified period; say a ‘quarter, year, etc. Interim Financial Statements Quarterly and semiannual financial statements are called interim financial statements and are normally prepared in a condensed form. Tt means that the disclosures required in them are far less than those equired in annual financial statements. Quarterly financial statements are normally unaudited but semiannual reports need to be at least reviewed by an auditor who is @ qualified professional accountant authorized to attest the authenticity of financial statements. Annual Financial StatementsFinancial statements prepared for a period of one year are called annual financial statements and are required to be audited by an auditor (a chartered accountant or a certified public accountant). Annual financial statements are normally published in an annual report which also Includes a directors’ report (also called management discussion and analysis) and an overview of the company, its operations and past performance. Income statement communicates the company's financial performance over the period while a balance sheet communicates the company's financial position at a point of time. The statement of cash flows and the statement of changes in equity tells us about how the financial position changed over the period. Disclosure notes to financial statements cover such material information which is not appropriate to be Communicated on the face of the main financial statements, Income Statement: Mr. HANDSOME INCOME STATEMENT For the month ended January 31, 2016 ‘Sales T 50,000.00, Less: Sales return and allowance 4,200.00 Sales discount 976.00 Total 176.00 Net Sales 47,824.00 Less: Cost of Goods Sold Merchandise Inventory — Beginning 0.00 Purchase (69,500.00 ‘Less: Purchase return and allowance 500.00 Purchase discount $580.00 ‘Goods Available for Sale (68,420.00 Less: Merchandising Inventory — End 729,000.00 Cost of Goods Sold [39,420.00 Gross income 8,404.00 Less: Operating expenses: Salaries Expense 38,200.00 ‘Supplies Expense 18,480.00 Rent Expense 12,000.00 Miscellaneous Expense 3,470.00 Electricity Expense 2,470.00 “Telephone Expense 1,494.00 Depreciation Expense 1,000.00 77,114.00 [Net Income (Loss) (68,710.00)STATEMENT OF CHANGES IN EQUITY Mr, HANDSOME ‘STATEMENT OF CHANGES IN EQUITY For the month ended January 31, 2016 Mr, Handsome, Capital - Beginning, January 01 500,000.00 Less: Drawings 10,000.00 Total 490,000.00 ‘Add: Net Income (Loss) (68,710.00) Mr. Handsome, Capital - End 424,290.00 BALANCE SHEET: Mr. HANDSOME BALANCE SHEET As of January 31, 2016 ASSETS: Current Assets: ‘Cash. 314,134.00 Merchandising Inventory 29,000.00 ‘Office Supplies 4,320.00 Prepaid Rent 24,000.00 “Total Current Assets 371,454.00 Non-Current Assets: Equipment ‘60,000.00 Less: Accumulated Depreciation 1,000.00, Net Equipment, 59,000.00 ‘Total Non-Current Assets '59,000.00 ‘TOTAL ASSETS 430,454.00, LIABILITIES AND CAPITAL ‘Current Liabilities: ‘Accounts Payable 5,200.00 Ublties Payable 3,964.00 “Total Liabilities 9,164.00 Capital Mr. Handsome, Capital 421,290.00 TOTAL LIABILITIES AND CAPITAL me 430,454.00‘STATEMENT OF CASH FLOWS (Direct Method) Mr. HANDSOME ‘STATEMENT OF CASH FLOWS For the month ended January 31, 2016 ‘Gash Flow from Operating Activities: Collections from customers 47,824.00 Payment of merchandise (68,420.00) Salaries paid (38,200.00) Payment for rental fee's (36,000.00) Payment to creditor (17,600.00) ‘Payment for miscellaneous expense (3,470.00) Net cash provided (used) in Operating Activities (115,366.00) Cash Flow from Investing Activities: Acquisition of Equipment (60,000.00) Net cash provided (used) in Investing Activities (60,000.06) | ‘Gash Flow from Financing Activities: Mr. Handsome, investment 500,000.00 Mr. Handsome, drawings (40,000.00) Net cash provided (used) in Financing Activities Net increase (decrease) in Cash ‘Add: Cash Balance, January 01, 2016 Cash Balance, January 31, 2016