The Cycle

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5

Unit 5

The Cycle

Learning Objectives1. Describe the accounting cycle and fiscal

period and the steps necessary to complete the accounting cycle.

2. Explain the accrual basis of accounting and use it to identify and journalize necessary adjusting entries to complete the accounting cycle.

3. Complete the end of fiscal period worksheet and close temporary accounts.

4. Analysis: Calculate and explain Gross Profit and Gross Profit percentage

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Objective 5.1: Accounting Cycle and Fiscal

PeriodAccounting information is divided into distinct time periods (fiscal

periods) according to the information needs of the firm

O5.1

The Accounting Cycle refers to the process that is used repeatedly to divide accounting

Information into time periods

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Equity

BALANCE SHEET

Assets Liabilities

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

0

0

1

2

5

2

4

7

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

7

10

BEGINNING OF FISCAL

PERIOD

END OF FISCAL PERIOD

Income statement

accounts start at zero then add activity through

the fiscal period.

At the end of the cycle,

the $3 in net income is moved

(closed) to the equity section of

the balance sheet.

Accounting Cycle

O5.1

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JOURNAL

1. Transactions are journalized and posted.

ACCOUNT

LEDGERS

Steps to complete the cycle

TRANSACTIONS

O5.1

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JOURNAL

2. End of fiscal period adjustments are journalized and posted

ACCOUNT

LEDGERS


ADJUSTMENTS

O5.1

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Equity

BALANCE SHEET

Assets Liabilities

3. Financial Statements are prepared

ACCOUNT LEDGERS


Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

O5.1

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Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Move Profit or Loss to Equity and set

Revenue and Expense accounts to

zero

5. The process is repeated for the next cycle.

5. Temporary accounts are closed

10

0

0

07


O5.1

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Objective 5.2: Accrual basis & Adjusting entries

Accrual is the process of recording financial activity based on whether a transaction has

occurred as opposed to recording financial activity on whether cash has been exchanged (cash basis

accounting).

O5.2

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We must stop at the end of the fiscal period and ask if any adjusting entries (AJE) need

to be made to remain consistent with the accrual basis of accounting.

The idea of accrual during the adjusting process focuses on Income and Expense accounts for

the fiscal period just ended.

All adjusting entries (AJE) affect at least one income statement account and

one balance sheet account.

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Why do we need to make adjusting entries?

Revenue is recorded when it is earned and receivable, whether

cash is paid or not.

•Revenue Recognition Concept•Matching Concept

Expenses must be matched (recorded) in the same period in which they where incurred to

generate the revenues recorded in that period (whether they have been

paid for with cash or not.

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Deferrals (Items previously recorded)Cash paid or received before

the revenue or expense is recognized

Prepaid ExpensesPrepaid InsurancePrepaid Supplies

Adjusting Entries

Accrued RevenuesFee Income

Consulting IncomeInterest Income

Accruals (Items not previously recorded)

Cash paid or received afterthe revenue or expense

is recognized

Accrued ExpensesInterest Expense

Consulting ExpenseWages Expense

DepreciationEquipmentBuildings

Unearned RevenueCustomer Deposits

Tickets Paid in Advance

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In this course of study, all adjusting entries (AJE) affect at least

one income statement account and one

balance sheet account.

ProfitDebit Credit or

Loss

Expenses

BALANCE SHEET INCOME STATEMENT

Assets Liabilities Revenue

Equity

No cash is

involved.

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Nisanov Distributors is completing their fiscal year

end. At the beginning of the year, the firm had $2,350 of office supplies on hand. The physical count at the end of

the year is $550.

December 31

O5.2

Which accounts are involved?

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CashAccounts ReceivableOffice SuppliesInventoryPrepaid InsuranceOffice Equipment

Assets

Accounts PayableWages PayableTaxes PayableUnearned RevenueNotes Payable

Frieda, CapitalFrieda, Drawing

Liabilities + Equity

Balance Sheet

SalesConsulting Revenue

Income Statement

Cost of Goods SoldWages ExpenseRent ExpenseUtilities ExpenseInsurance ExpenseInterest expenseSupplies expense

Profit

Loss

OR

Supplies should go down,

Supplies expense should go up

O5.2

Nisanov Distributors

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The balance in the Office Supplies (asset) account after the adjusting entry

should be the same as the physical count.

Therefore, the adjusting entry should be $2,350 -

$550 = $1,800.

December 31

O5.2

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Debit Credit

2007 0.00

31-Dec Adjusting Entry J1 1,800.00 1,800.00

LEDGER

Account Name: SUPPLIES EXPENSE Acct #: 575

Date ItemPost Ref. Debit Credit

BALANCE

Page 1

Date Description PR Debit Credit

31-Dec Supplies Expense 575 1,800.00

Office Supplies 135 1,800.00

Adjust for supplies used

GENERAL JOURNAL

Adjusting Entries

Debit Credit

2007 Balance Forward 2,350.00

31-Dec Adjusting Entry J1 1,800.00 550.00

LEDGER

Account Name: OFFICE SUPPLIES Acct #: 135


BALANCE

O5.2

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At the beginning of the year, Nisanov Distributors

had $16,000 Unearned Consulting Revenue

recorded. At year end, $8,500 of that amount

had been earned.

December 31

O5.2


We finished $8,500

worth of consulting!

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CashAccounts ReceivableOffice SuppliesInventoryPrepaid InsuranceOffice Equipment

Assets




Balance Sheet

SalesConsulting Revenue

Income Statement


Profit

Loss

OR

Unearned Revenue should go down,

Consulting Revenue should go up

O5.2


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The balance in the Unearned Revenue (liability) account before the adjusting entry is

$16,000; if $8,500 of this amount has been earned,

the adjusting entry should be $8,500.

December 31

O5.2

We finished $8,500

worth of consulting!

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Debit Credit

2007 0.00


LEDGER

Account Name: CONSULTING REVENUE Acct #: 420


BALANCE

Page 1


31-Dec Unearned Revenue 240 8,500.00

Consulting Revenue 420 8,500.00

Adjust for consulting earned

GENERAL JOURNAL

Adjusting Entries

Debit Credit



LEDGER

Account Name: UNEARNED REVENUE Acct #: 240


BALANCE

O5.2

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Nisanov Distributors purchased a $50,000 two

year certificate of deposit at the beginning of the year earning 4% annually. An adjusting entry is required for

interest earned.

December 31

O5.2


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CashAccounts ReceivableInterest ReceivableOffice SuppliesInventoryPrepaid InsuranceOffice Equipment

Assets




Balance Sheet

SalesConsulting RevenueInterest Income

Income Statement


Profit

Loss

ORBoth accounts

should increase

O5.2


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Interest earned is $50,000 x 4% = $2,000

Therefore, the adjusting entry is $2,000 which will increase revenue for the fiscal period just ending

even though the interest will not be received until

maturity of the CD at the end of the 2nd year.

December 31

O5.2

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Debit Credit

2007 0.00


LEDGER

Account Name: INTEREST INCOME Acct #: 445


BALANCE

Page 1


31-Dec Interest Receivable 115 2,000.00

Interest Income 445 2,000.00

Adjust for interest income

GENERAL JOURNAL

Adjusting Entries

Debit Credit

2007 Balance Forward 0.00


LEDGER

Account Name: INTEREST RECEIVABLE Acct #: 115


BALANCE

O5.2

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Nisanov Distributors has seven employees with daily payroll costs of $135 each. Employees work Monday through Friday and are paid in full on Friday of each week. Year end (Dec 31) falls on Wednesday this year. An

adjusting entry is required for accrued but unpaid payroll.

December 31

O5.2


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CashAccounts ReceivableInterest ReceivableOffice SuppliesInventoryPrepaid InsuranceOffice Equipment

Assets




Balance Sheet


Income Statement


Profit

Loss

ORBoth accounts

should increase

O5.2


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Unpaid payroll daily is 7 x $135 = $945. There are 3 days

accrued but unpaid, Monday, Tuesday and

Wednesday. Total adjusting entry is 3 x

$945 = $2,835

December 31

O5.2

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Debit Credit

2007 0.00


LEDGER

Account Name: WAGES PAYABLE Acct #: 275


BALANCE

Page 1


31-Dec Wages Expense 575 2,835.00

Wages Payable 275 2,835.00

Adjust for accrued payroll

GENERAL JOURNAL

Adjusting Entries

Debit Credit



LEDGER

Account Name: WAGES EXPENSE Acct #: 575


BALANCE

O5.2

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Nisanov Distributors purchased office equipment at the beginning of the current year at a cost of $25,000;

salvage value 0; useful life 5 years. Complete the adjusting entry to

record the first year’s depreciation.

December 31

O5.2


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CashAccounts ReceivableInterest ReceivableOffice SuppliesInventoryPrepaid InsuranceOffice EquipmentAccumulated Depreciation -Office Equipment

Assets




Balance Sheet


Income Statement

Cost of Goods SoldWages ExpenseRent ExpenseUtilities ExpenseInsurance ExpenseDepreciation ExpenseSupplies expense

Profit

Loss

ORBoth accounts

should increase

O5.2


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O2.3

(150)

Book Value –Equipment 700

The net effect or

“weight” on the balance

sheet is often called

the Book Value.

850

ContraAccount

Equipment

Accumulated Depreciation

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Cost – Salvage value = Depreciable amount

divided by useful life = annual depreciation.

December 31

O5.2

$25,000 - $0 = $25,000 $25,000/ 5 =

$5,000

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Debit Credit

2007 0.00


LEDGER

Account Name: ACCUMULATED DEPRECIATION Acct #: 185


BALANCE

Page 1


31-Dec Depreciation Expense 585 5,000.00

Accumulated Depreciation 185 5,000.00

Adjust for annual depreciation

GENERAL JOURNAL

Adjusting Entries

Debit Credit



LEDGER

Account Name: DEPRECIATION EXPENSE Acct #: 585


BALANCE

O5.2

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Objective 5.3: Worksheet

At the end of the fiscal period a worksheet is often used to schedule adjusting entries,

prepare financial statements and schedule closing entries. The

process starts with a Trial Balance

O5.3

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ACCOUNT NAME

Debit CreditCash -Checking 22,150Cash -Savings 5,500Accounts Receivable 65,700Interest Receivable 245Merchandise Inventory 198,300Office Supplies 1500Prepaid Insurance 6,700Equipment 34,200Accum. Depr. EquipAccounts Payable 45,345Wages PayableUnearned Revenue 10,000Equip. Loan Payable 71,400T. Sally, Capital 131,850T. Sally, Drawing 5,000Merchandise Sales 1,225,000Discount Card SalesCost of Goods Sold 895,600Wages Expense 54,000Rent Expense 115,200Advertising Expense 34,000Utilities Expense 39,000Supplies ExpenseInsurance ExpenseDepr. Exp., EquipInterest IncomeInterest Expense 6500

1,483,595 1,483,595

Sally DistributorsTRIAL BALANCE

31-Dec-07

The Trial Balance is simply a report that lists all of the account balances in the

accounting system•debit balance on the left and•credit balances on the right.

Total debits must = Total credits

Trial Balance

O5.3

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Assets Liabilities

EquityExpenses

Revenue

Except for CONTRA accounts, the Trial Balance follows this picture. Contra

accounts must be listed according to their balance, debits left – credits right

Trial Balance

Owner, Drawing

O5.3

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Worksheet & the Trial Balance

The worksheet begins with a

Trial Balance

O5.3

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Completing the Worksheet

Adjusting entries are entered

into the next column

O5.3

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An Adjusted Trial Balance is prepared in the next columnby updating the Trial Balance

with the effectsof the adjusting entries

O5.3

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Completing the

Worksheet

The adjusted accountBalances are then separated into Income Statement and

Balance Sheet columns

O5.3

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Equity

BALANCE SHEET

Assets Liabilities

Profitor

Loss

Expenses

INCOME STATEMENT

RevenueFinancial statementsare prepared directlyfrom the Worksheet

O5.3

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Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

Equity

BALANCE SHEET

Assets Liabilities

O5.3

EXAMPLE

The completed Worksheet can be used to prepare the end of fiscal period financial

statements

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O5.3 Excess of credits

Excess of debits

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Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580

Cost of Goods Sold 435,500

Gross Profit 459,080

Wages Expense 218,120Rent Expense 52,500Advertising Expense 32,200Utilities Expense 13,660Supplies Expense 650Insurance Expense 5,000Depr. Exp., Equip 2,000Interest Income (500)Interest Expense 850

Subtotal 324,480

Net Profit 134,600

All Fit Health SupplyIncome Statement

For the Year ending December 31, 2007

Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580


Gross Profit 459,080


Subtotal 324,480

Net Profit 134,600



Notice the net income is

transferred to the Equity section to properly

reflect the new Equity

balance.

Cash 45,125 Accounts Payable 59,140Accounts Receivable 32,975 Wages Payable 3,000Interest Receivable 500 Unearned Revenue 0Merchandise Inventory 247,850 Equip. Loan Payable 8,450Office Supplies 245Prepaid Insurance 0 C. Atlas, Capital (beginning) 131,850Equipment 11,000 less Drawing (1,345)Accum. Depr. Equip (2,000) add Net Profit 134,600

C. Atlas, Capital (ending) 265,105

Total assets 335,695 Total Liab. & Equity 335,695

All Fit Health SupplyBalance Sheet

As of December 31, 2007

Cash 45,125 Accounts Payable 59,140Accounts Receivable 32,975 Wages Payable 3,000Interest Receivable 500 Unearned Revenue 0Merchandise Inventory 247,850 Equip. Loan Payable 8,450Office Supplies 245Prepaid Insurance 0 C. Atlas, Capital (beginning) 131,850Equipment 11,000 less Drawing (1,345)Accum. Depr. Equip (2,000) add Net Profit 134,600

C. Atlas, Capital (ending) 265,105

Total assets 335,695 Total Liab. & Equity 335,695

All Fit Health SupplyBalance Sheet

As of December 31, 2007

Equity

BALANCE SHEET

Assets Liabilities

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

O5.3

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O5.3

Recall that the Income Statement is a temporary

collection of eventual changes to Equity


Loss

Expenses



Equity

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Income Statement accounts are temporary

accounts

We need to follow a careful process to insure the correct transfer of

Income Statement activity to the Equity section of the Balance Sheet.

This is referred to as the Closing process.

O5.3

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Closing Temporary Accounts

The closing process involves a step by step procedure to empty out the

Income Statement accounts to prepare for the next fiscal period.

To close an account simply means toselect an entry that forces the account

to a zero balance.

O5.3

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Closing Temporary Accounts

The first step in closing an account is to determine the ending balance in

the account

Once you know the ending balance,you can determine the closing entry required

O5.3

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100,000

100,000-0- -0-

SALES

100,000

100,000-0- -0-

SALES

Example -Closing Entry

O5.3

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100,000

100,000-0- -0-

SALES

100,000

100,000-0- -0-

SALES

Example -Closing Entry

O5.3

But how do we

balance this entry

in the Journal?

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We “invent” a special Equity account that is used to balance the closing

entries from Revenue and Expenses.

This account is called the Income Summary

account.

O5.3

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Loss

Expenses



Equity

REVENUEACCOUNTS

INCOME SUMMARY CORRAL

EXPENSEACCOUNTS

The Income Summary

account can be thought

of as a corral. It is

used to enclose the

fiscal period’s activity.

O5.3

Income Summar

y Account

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Debit Credit

2007 0.00

31-Dec Closing entry J1 100,000.00 100,000.00

LEDGER

Account Name: INCOME SUMMARY Acct #: 399


BALANCE

Page 1


31-Dec Sales 400 100,000.00

Income Summary 399 100,000.00

Close Sales to Income Summary

GENERAL JOURNAL

Using the Income Summary Account

Debit Credit


31-Dec Closing entry J1 100,000.00 0.00

LEDGER

Account Name: SALES Acct #: 400


BALANCE

O5.3

Sales account is now –0-.

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R

E

I

D

CLOSE REVENUE ACCOUNTS TO INCOME SUMMARY

CLOSE EXPENSE ACCOUNTS TO INCOME SUMMARY

CLOSE INCOME SUMMARY TO OWNER, CAPITAL

CLOSE DRAWING ACCOUNT TO OWNER, CAPITAL

O5.3

Closing Process –step by step

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EXPENSEACCOUNTS

REVENUEACCOUNTS

INCOME SUMMARY (CORRAL)

R

E

I

D

REVENUE

EXPENSE

INCOME SUMMARY

DRAWING ACCOUNT

O5.3

Closing Process –step by step

OWNER, CAPITALOWNER, CAPITAL

OWNER, DRAWINGOWNER, DRAWING

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Using a Worksheet to complete the Closing

process

To enhance your understanding of the Closing process, an optional

worksheet can be studied.

Review the following Worksheet example

O5.3

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ACCOUNT NAME

Debit Credit Debit Credit Debit CreditCash -Checking 35,125 35,125Cash -Savings 10,000 10,000Accounts Receivable 32,975 32,975Interest Receivable 500 500Merchandise Inventory 247,850 247,850Office Supplies 245 245Prepaid Insurance 0Equipment 11,000 11,000Accum. Depr. Equip 2,000 2,000Accounts Payable 59,140 59,140Wages Payable 3,000 3,000Unearned Revenue 0Equip. Loan Payable 8,450 8,450C. Atlas, Capital 131,850 1,345 134,600 265,105C. Atlas, Drawing 1,345 1,345Merchandise Sales 869,580 869,580Discount Card Sales 25,000 25,000Cost of Goods Sold 435,500 435,500Wages Expense 218,120 218,120Rent Expense 52,500 52,500Advertising Expense 32,200 32,200Utilities Expense 13,660 13,660Supplies Expense 650 650Insurance Expense 5,000 5,000Depr. Exp., Equip 2,000 2,000Interest Income 500 500Interest Expense 850 850Income Summary 760,480 895,080

" " 134,6001,099,520 1,099,520 1,791,505 1,791,505 337,695 337,695

All Fit Health SupplyClosing Worksheet

31-Dec-07CLOSING ENTRIES POST CLOSING

TRIAL BALANCEADJUSTED TRIAL

BALANCE

RE

I

D

O5.3

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O5.3

The resulting balances

in the Income

Statement accounts

and Owner’s Drawing are now

zero.

ACCOUNT NAME

Debit Credit Debit Credit Debit CreditCash -Checking 35,125 35,125Cash -Savings 10,000 10,000Accounts Receivable 32,975 32,975Interest Receivable 500 500Merchandise Inventory 247,850 247,850Office Supplies 245 245Prepaid Insurance 0Equipment 11,000 11,000Accum. Depr. Equip 2,000 2,000Accounts Payable 59,140 59,140Wages Payable 3,000 3,000Unearned Revenue 0Equip. Loan Payable 8,450 8,450C. Atlas, Capital 131,850 1,345 134,600 265,105C. Atlas, Drawing 1,345 1,345Merchandise Sales 869,580 869,580Discount Card Sales 25,000 25,000Cost of Goods Sold 435,500 435,500Wages Expense 218,120 218,120Rent Expense 52,500 52,500Advertising Expense 32,200 32,200Utilities Expense 13,660 13,660Supplies Expense 650 650Insurance Expense 5,000 5,000Depr. Exp., Equip 2,000 2,000Interest Income 500 500Interest Expense 850 850Income Summary 760,480 895,080

" " 134,6001,099,520 1,099,520 1,791,505 1,791,505 337,695 337,695

All Fit Health SupplyClosing Worksheet

31-Dec-07CLOSING ENTRIES POST CLOSING

TRIAL BALANCEADJUSTED TRIAL

BALANCE

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JOURNAL

Closing entries are journalized and posted.

ACCOUNT

LEDGERS

The closing entries must be formally entered into the accounting system

CLOSING ENTRIES

O5.1

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Closing entries in

the journal

O5.1

Page 13


Closing Entries

12/31/x7 Merchandise Sales 869,580

Discount Card Sales 25,000

Interest Income 500

Income Summary 895,080



Wages Expense 218,120

Rent Expense 52,500

Advertising Expense 32,200

Utilities Expense 13,660

Supplies Expense 650

Insurance Expense 5,000

Depr. Expense -Equipment 2,000

Interest Expense 850


C. Atlas, Capital 134,600

C. Atlas, Capital 1,345

C. Atlas, Drawing 1,345

JOURNAL

R

E

I

D

Net income moves to Owner’s Equity.

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All of the

closing activity affects

Owner’s Equity.

R

E

I

DO5.3

Closing Overview

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Objective 5.4: Gross Profit and Gross Profit percentage

The Gross Profit is a subtotal on the Income Statement for firms that sell merchandise (as opposed to those

that sell services).

O5.4

Gross Profit = Net Sales – Cost of Goods SoldGross Profit % = Gross Profit / Net Sales

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%Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580


Gross Profit 459,080 51%


Subtotal 324,480

Net Profit 134,600



%Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580


Gross Profit 459,080 51%


Subtotal 324,480

Net Profit 134,600



The Gross Profit percentage is used to

compare managements success in pricing and

purchasing merchandise from one period to the

next and to competitors and industry averages.

O5.4

459,080 / 894,580 = 51%.

Or $.51 out of every sales dollar was left to

cover remaining expenses and profit after the cost of sold

merchandise was deducted.

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End Unit 5

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