Completing the Accounting Cycle Chapter 4 1 Copyright

Completing the Accounting Cycle Chapter 4 1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives Prepare an accounting worksheet Use the worksheet to prepare financial statements Close the revenue, expense, and dividend accounts Prepare the post-closing trial balance 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives Classify assets and liabilities as current or long-term Describe the effect of various transactions on the current ratio and the debt ratio 3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Steps in the Accounting Cycle Start with the beginning account balances. Prepare the post-closing During the period trial balance. Journalize and post the closing entries. Analyze and journalize transactions as they occur. Post to the accounts. At the end of the period Prepare the financial statements. Compute the unadjusted balance in each account. Enter the trial balance and complete the worksheet. Journalize and post adjusting entries IPO anyone? 5 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1 Prepare an accounting worksheet 6 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet A tool used to summarize information It is not a: journal ledger financial statement Computerized spreadsheets & sensitivity analysis Contains heading similar to statements 7 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 1 Enter account titles unadjusted balances Total the amounts 8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 2 Enter the adjusting entries Total the amounts Remember, these still need to be journalized and posted 9 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 3 $2, 200 (Dr) + $400 (Dr) = $2, 600 Compute each account’s adjusted balance Enter the adjusted balance in the adjusted trial balance column 10 $600 (Cr) - $200 (Dr) = $400 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 4 Draw an imaginary line above the first revenue account Every account above the line are Balance Sheet accounts Every account below the line are Income Statement accounts Copy the totals to the appropriate column 11 Assets Liabilities Equity Revenue Expenses Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 5 Using the income statement columns, compute net income Revenues minus expenses Enter net income as the balancing amount Revenues total = $7, 600 Expenses total = $3, 900 Net income = $3, 700 12 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Step 5 Also enter net income as a balancing amount on the balance sheet Net income from previous columns 13 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Complete Worksheet 14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Work opportunity Draper Consulting, Inc. Just complete the instruction for completing the worksheet, not the rest of them. Draw a line between BS and IS accounts Move Income statement accounts Sub total each column Plug in net income to balance & finalize totals Move Balance sheet accounts Sub total each column Plug in net income to balance & finalize totals 18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2 Use the worksheet to prepare financial statements 19 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Preparing Financial Statements from a Worksheet The worksheet contains the financial statement data. Income statement column equals the income statement The Net income total is for our retained earnings statement Connects the Net income to the balance sheet Balance sheet column equals the balance sheet Worksheet is an internal document Financial statements are for external users 20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Compare the balances here with the Income Statement appearing next. Income Statement 21 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Preparing Financial Statements Beginning Retained earnings is found in the balance sheet columns, along with Dividends Net income is found in the income statement columns Ending Retained earnings is computed here Carry the ending Retained earnings balance to the balance sheet 22 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Worksheet Balance Sheet Compare the balances on the worksheet with the Balance Sheet appearing next. 23 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Classified balance sheet Liquidity measures quickness of cash How quickly an item can be converted into cash Classified Balance Sheet Lists assets in order of their liquidity Current Assets Converted to cash, sold, or used Most commonly within one year 24 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Current Assets Examples: Cash Accounts receivable Supplies Prepaid expenses Inventory 25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Long-Term Assets Not converted to cash within the current year Categories Plant assets Land Building Furniture Equipment Long-term investments Other assets 26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Current Liabilities Must be paid either with cash or goods and services within one year Examples: Accounts payable Notes payable due within one year Salary payable Interest payable Unearned revenue 27 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Long-Term Liabilities Are not due within the current year Examples: Notes payable with due dates over one year Mortgages 28 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Classified Balance Sheet: Report Form Report form should be read top to bottom 30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Work opportunity Draper Consulting, Inc. Just complete instruction for preparing financial statements, not the rest. Prepare Income statement first Prepare Statement of retained earnings second Prepare Classified Balance sheet third Remember to update retained earnings balance! 32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Draper’s Classified Balance Sheet 33 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3 Close the revenue, expense, and dividend accounts 35 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Closing the Accounts Occurs at the end of the period Gets accounts ready for next period Zeroes out revenue and expense accounts Updates Retained earnings to the ending balance Four step process Close temporary accounts Closing entries do not capture new transactions like adjusting entries did. All closing entries do is transfer balances to their permanent destinations. 36 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Temporary and Permanent Accounts Temporary Closed at the end of the period Revenues Expenses Dividends Start next period with a zero balance 37 Permanent Not closed at the end of the period Assets Liabilities Common stock Retained earnings Ending balance carries forward to next period Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Closing the Accounts Step 1 – Close Revenues to Income summary account Step 2 – Close individual Expense accounts to Income summary account Step 3 – Close Income summary account to Retained earnings account Step 4 - Close Dividends account to retained earnings account 38 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Four Step Closing Process The closing process 39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The adjusted trial balance from the January worksheet of Silver Sign Company is shown: Requirement: 1. Journalize Silver’s closing entries at January 31. 40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1. Journalize Silver’s closing entries at January 31. Jan. 31 Service revenue Income summary 31 Income summary Salary expense Rent expense Depreciation expense Supplies expense Utilities expense 41 $16, 800 6, 200 3, 600 1, 400 200 600 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

31 Income summary Retained earnings 31 Retained earnings Dividends 10, 600 800 2. How much net income or net loss did Silver earn for January? How can you tell? Silver had net income of $10, 600. We know this because service revenue exceeded total expenses. 42 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Work opportunity Draper Consulting, Inc. Just complete the instruction for closing entries and posting them Link to Draper Consulting, Inc. Adjusted trial balance 43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

4 Prepare post-closing trial balance 44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Post-Closing Trial Balance List of permanent accounts and their balances after posting closing entries Total debits and credits must be equal Same accounts as on the balance sheet 45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

After closing its accounts at July 31, 2012, Goodrow Electric Company had the following account balances: 1. Prepare Goodrow’s post-closing trial balance at July 31, 2012. 46 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Goodrow Electric Company Post-Closing Trial Balance July 31, 2012 Cash $ Accounts receivable Supplies Equipment Accumulated depreciation Land Accounts payable Unearned service revenue Long-term liabilities Common stock Retained earnings Total $ 47 100 1, 600 200 4, 500 $ 1, 300 1, 200 1, 100 1, 400 800 1, 000 2, 000 7, 600 $ 7, 600 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

6 Use the debt ratio, current ratio and the interest coverage ratio to evaluate a company 58 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting Ratios To measure the business’s financial position Decision makers use financial ratios Widely used debt analysis ratios: Debt ratio Current ratio Extra: Interest coverage ratio 59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Ratios A ratio is a mathematical expression of the relationship between two items. Miles per hour Risk to Reward ratio Miles per gallon Defects per thousands Fun to trouble ratio Odds of winning Hundreds more uses Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Ratios We can compare business ratios with company history, competitors, or another industry to learn several things about businesses. Debt exposure Profitability Managerial effectiveness Value Strategy Efficiency Impending doom Hundreds more uses Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Ratios are evidence to a story. The story is what really matters. Is the company borrowing responsibly? Debt exposure aka leverage Find a tool to measure responsible borrowing Debt Ratio: debt ÷ assets The #’s: 810 ÷ 900 = 90% The story 50% is optimal, they have way too much debt and way too little equity. This is too much borrowing compared to the industry norm of equal liability and equity financing. They may be in danger of failing to make the associated interest payments and in paying back principle. If they can’t pay, the equity holders lose their entire investment. This is very risky. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Debt Ratio Total liabilities Total assets Indicates the proportion of a business’s assets that are financed with debt Measures business’s ability to pay its debts Rule of thumb: Above 60% is considered unsafe 50% is widely regarded as optimal Lower may suffer from unnecessarily high cost of capital 63 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Current Ratio Current assets Current liabilities Measures a company’s ability to pay its current liabilities Rule of thumb Strong current ratio is 1. 5 Ample cash on hand, with little wasteful excess 1. 0 is either dangerously low, or well managed How to tell? 64 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Interest Coverage Ratio Earnings before interest & taxes Interest expense Compares earnings to borrowing costs. If too much earnings are going to lenders, then the company isn’t handling their debt well. Rule of thumb Norm is between 2. 0 and 3. 0 Twice as much earnings as interest charges Lower than 2. 0 means high interest is consuming over half of the company’s earnings Leaves little margin of performance safety 65 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Yahoo debt analysis www. yahoo. com/finance Debt ratio Current ratio Interest coverage ratio Liabilities ÷ Assets Current Assets ÷ Current liabilities EBIT ÷ Interest expense Compare each number against benchmark Judge each number and interpret 66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Your turn Groups of up to 6 One laptop per team User name: default Password: mpcmpcmpc Follow the Yahoo Finance debt analysis procedure Report on the debt analysis reporting form 20 minutes of work, not enough to finish everyone Submit individual sheet for points next class 67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Work opportunity Practice Set Page 250 Complete the worksheet. Prepare financials Prepare closing entries Prepare post-closing trial balance 68 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Complete Worksheet 69 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Next Time Be on time or you will miss out on the action Be prepared to execute the entire accounting cycle at warp speed If you put maximum effort into it, you will master the accounting cycle and get the point of the financial statements This is a huge help toward your test preparation, but only if you are prepared Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Heart of Texas Telecom has these account balances at December 31, 2012: Note payable, long-term Prepaid rent Salary payable Service revenue Supplies $ 7, 800 2, 300 3, 000 29, 400 500 Accounts payable Accounts receivable Cash Depreciation expense Equipment $ 3, 700 5, 700 3, 500 6, 000 15, 000 1. Compute Heart of Texas Telecom’s current ratio and debt ratio. Total current assets = Total current liabilities Total liabilities $14, 500 = = Total assets $27, 000 Current ratio = Debt ratio $12, 000 6, 700 = = 1. 79 0. 54 2. How much in current assets does Heart of Texas Telecom have for every dollar of current liabilities that it owes? Heart of Texas Telecom has $1. 79 of current assets for every dollar of current liabilities that it owes. 71 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 4 Summary The worksheet is a tool that puts the whole accounting process in one place. Remember that debits = credits in the first three columns. Columns 4 and 5 (Income Statement and Balance Sheet) debits do not equal credits until you post the net income or net loss for the period. The formal financial statements yield the same net income or loss that is shown on the worksheet. 72 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 4 Summary Closing the accounts is just like starting a new baseball game. The score is 0 -0. All temporary account balances are zero after closing. The post-closing trial balance contains the same accounts that the balance sheet contains— assets, liabilities, Common stock, and Retained earnings. 73 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 4 Summary Classification means dividing assets and liabilities between those that will last less than a year (current) and those that will last longer than a year (long-term). The classified balance sheet still represents the accounting equation and must balance (Assets = Liabilities + Equity). 74 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 4 Summary The current ratio measures liquidity within one year by comparing current assets to current liabilities. The debt ratio measures the ability to pay liabilities in the long term by comparing all liabilities to all assets. The different ratios give different views of a company’s financial health. 75 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

76 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 77 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.