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03- Accounting Cycle Notes.doc

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Jocelyn King

Review of the Accounting Cycle - Supplementary notes The accounting cycle begins with the identification of a transaction that must be recorded. A transaction involves an exchange of money, goods, or services between the firm and an external party. Examples include the sale of goods, the purchase of supplies, and the payment of salary to employees. Transactions are recorded using the double-entry method of book-keeping that is based on the following equation: Assets = Liabilities + Owners' Equity The left side of this equation comprises everything owned by the business (its assets). The right hand side of the equation tells us how the assets were financed. Liabilities are the result of financing with debt and owners' equity represents the share of assets that have been financed by the owners. The best way to learn the steps in the accounting cycle is to work through an example using a case. Below you will find the Larry Owens Real Estate Limited case. Assume that Larry Owens has started a new company in the real estate industry; he plans to sell real estate and also to manage properties on behalf of clients. He starts the business on July 1, 2011. On the following pages, you will be given a series of transaction for Larry Owens Real Estate Limited and will record the transactions and prepare the financial statements for the business’ first month of operation. Note: the steps followed here are the same steps you will follow in your case 1 assignment. These notes will be very useful to you in completing this assignment. Case: Larry Owens Real Estate Consider the following sample transactions which occur in the month of July, 2011: (1) Larry Owens invests $50,000 of his own money in Owens Real Estate Limited (OREL) by purchasing share capital. (2) OREL purchased a $30,000 business automobile on credit (a 36 month car loan). In the case of both transactions (1) and (2), the assets of the business have increased: cash has increased by $50,000 and automobiles by $30,000. However, transaction (1) has increased Larry's equity in the business (owner's equity) and liabilities have increased by 30,000. Supplementary Notes – Accounting Cycle Page 1 The double entry method records each transaction in two places. We can expand the accounting equation as follows: Assets = Liabilities + Owners' Equity Or in more detail we could say: Cash + Automobile = Liabilities + Owner's Equity $50,000 + $30,000 = $30,000 + $50,000 We have shown the $50,000 as an increase both to assets and owner’s equity and the $30,000 as an increase both to automobile and to liabilities. Hence, the equality of the accounting equation is maintained, which provides us with a check on the accuracy of our recording. If subsequent to recording transactions the accounting equation did not balance, we would know that we had made an arithmetic error. Now consider the following transactions for the month of July: (1) Larry Owens invested $50,000 in a real estate agency by purchasing share capital. (2) Purchased a $30,000 for a business automobile on credit. (3) He paid three months office rent in advance, $3,000. (4) Purchased office equipment for cash, $10,000 (5) Purchased on credit from Standard Supply Company office supplies, $600, and from Office Depot office equipment, $3,500. (6) Sold unneeded office equipment to Dale Hall, $1,000 cash and $500 to be paid at a later date. (7) Collected $500 from Dale Hall. (8) Paid Office Depot $1,750 of the amount owed for equipment. (9) Sold a house and collected an $8,500 commission. (10) Paid the secretary's salary for the first two weeks of the month, $1,000. (11) Signed a contract to manage an apartment building for $500 per month. Collected the management fee for the last half of July and the month of August, a month and a half, $750 (12) Paid the secretary's salary for the second two weeks of July, $1,000. (13) Paid a $200 dividend to himself as the sole shareholder. (14) Paid the monthly telephone bill, $200. (15) Paid for gas and oil used in the agency car, $250. (16) Paid for newspaper advertising that had appeared, $600. Note that the number shown with each account entry corresponds to the transaction number. Each account has both a left-hand (debit) side and right-hand (credit) side. A debit represents an increase in assets or a decrease in liabilities or owners' equity. A credit represents an increase in liabilities or owners' equity and a decrease in assets. The terms debit and credit therefore take on opposite signs as we change sides in the accounting equation. We first record transactions in journal entries. The journal entries are then entered in (posted) to the accounts. Journal entries for the above 16 transactions are shown below. The debit side of the entry is shown first, and the credit side on the line below, slightly indented. Supplementary Notes – Accounting CyclePage 2 (1) Cash 50,000 Common Stock 50,000 (2) Automobile 30,000 Car Loan 30,000 (3) Prepaid Rent 3,000 Cash 3,000 (4) Office Equipment 10,000 Cash 10,000 (5) Office Supplies 600 Office Equipment 3,500 Accounts Payable 4,100 (6) Cash 1,000 Accounts Receivable 500 Office Equipment 1,500 (7) Cash 500 Accounts Receivable 500 (8) Accounts Payable 1,750 Cash 1,750 (9) Cash 8,500 Commissions Earned 8,500 (10) Office Salaries Expense 1,000 Cash 1,000 (11) Cash 750 Unearned Management Fees 750 (12) Office Salaries Expense 1,000 Cash 1,000 (13) Dividends 200 Cash 200 (14) Telephone Expense 200 Cash 200 (15) Gas, Oil, and Repairs 250 Cash 250 (16) Advertising Expense 600 Cash 600 See T accounts on next page. Supplementary Notes – Accounting CPage 3 Assets = Liabilities + Owner’s Equity Cash Accounts Payable Common Stock (1) 50,000 (2) 30,000 (8) 1,750 (5) 4,100 (1) 50,000 (3) 3,000 (6) 1,000 (4) 10,000 2,350 50,000 (7) 500 (8) 1,750 (9) 8,500 (10) 1,000 Unearned Management Fees Dividends (11) 750 (12) 1,000 (13) 200 (11) 750 (13) 200 (14) 200 (15) 250 750 200 (16) 600 12,750 Car loan Commissions Earned Accounts Receivable (9) 8,500 (6) 500 (7) 500 (2) 30,000 8,500 0 30,000 Prepaid Rent Office Salaries Expense (3) 3,000 (10) 1,000 3,000 (12) 1,000 2,000 Office Supplies Telephone Expense (5) 600 (14) 200 600 200 Automobile Gas, Oil, and Repairs (2) 30,000 30,000 (15) 250 250 Advertising Expense Office Equipment (16) 600 (4) 10,000 (6) 1,500 (5) 3,500 600 1,2000 Supplementary Notes – Accounting CyclPage 4 Sub Ledgers Before moving on, consider the $2,350 balance in Accounts Payable. It is important to know not just the total in this account, but also the balances due to individual suppliers so that cheques can be written to pay the correct supplier and to ensure that all suppliers are paid appropriately. Formally, a company keeps track of amounts due to individual suppliers through the maintenance of an Accounts Payable subledger. Each time a journal entry is made to Accounts Payable, an entry is also made to the individual supplier account in the subledger. Journal entries (5) and (8) involve Accounts Payable. They would be reflected in the Accounts Payable subledger as follows: Standard Supply Company Office Depot (5) 600 (8) 1750 (5) 3500 600 1750 A Trial balance of the Accounts Payable subledger follows: Standard Supply Company $ 600 Office Depot 1,750 $ 2,350 Note that this equals the balance in the Accounts Payable account. This is as we expect, since the Accounts Payable subledger is nothing more than a breakdown of that account by individual supplier. When Owens Real Estate Limited develops a client base, it will also need to set up an Accounts Receivable subledger in order to maintain a breakdown of amounts owing from individual clients. Supplementary Notes – Accounting CyclePage 5 If we add up the balances in these accounts, we can enter them in a trial balance and check that the sum of the debits equals the sum of the credits, as follows: Owens Real Estate Limited Trial Balance July 31, 2011 Debit Credit Cash $42,750 Prepaid Rent 3,000 Office Supplies 600 Automobile 30,000 Office Equipment 12,000 Accounts Payable $2,350 Unearned Management Fees 750 Car Loan 30,000 Common Stock 50,000 Dividends 200 Commissions Earned 8,500 Office Salaries Expense 2,000 Telephone Expense 200 Gas, Oil, and Repairs 250 Advertising Expense 600 Totals $91,600 $91,600 Now assume that Larry would like to prepare financial statements at the end of July. We will prepare an income statement to show revenues earned during the period, and the expenses incurred in order to earn these revenues. We will also prepare a balance sheet in order to show the amounts of the various assets and liabilities and the closing owner's equity for the period. The trial balance as it now stands does not show proper account balances. That is because the nature of some of the items has changed with the passage of time from when they were originally recorded. Consider transaction (2), the payment of three months rent in advance. Assume this payment was made on July 1. We recorded this transaction as a debit to prepaid rent. However, now it is the end of July. One month has passed. Therefore, one-third of the $3,000 originally paid is no longer prepaid. Assets used up in the course of doing business become expenses. We record this in the following adjusting entry (journal entries are numbered beginning from where the previous sequence of journal entries left off): Supplementary Notes – Accounting CycPage 6 (17) Rent Expense 1,000 Prepaid Rent 1,000 Similarly, physical assets (the automobile and the office equipment) will wear out. We call the wear and tear on such assets amortization. Assume the automobile has depreciated by 1/10 of its original cost. Assume the amortization on the office equipment is $1200. We record this amortization as follows: (18) Amortization Expense 4,200 Accumulated Amortization-Automobile 3,000* Accumulated Amortization-Office Equipment 1,200 *1/10 X $ 30,000= $3,000 The Accumulated Amortization accounts are called contra-asset accounts. In order to preserve the original cost of the fixed assets intact, we do not credit the Automobile and Office Equipment accounts directly. Instead, we credit the contra-accounts whose credit balances are deducted from the debit balances in the asset accounts themselves when financial statements are prepared. Larry collected $750 in July, representing management fees for half of July and all of August (transaction # 11). It is now July 31, so he has not earned the $500 portion of the fee that pertains to August. He has, however, earned the $250 portion of the fee pertaining to July. We therefore need to remove this $250 from the liability account, Unearned Management Fees, and assign it to a revenue account: (19) Unearned Management Fees 250 Management Fees Earned 250 In order to prepare financial statements, the adjusting journal entries (17) through (19) are posted to the trial balance and the balances extended out to the income statement and balance sheet columns. This document is referred to as a worksheet. The financial statements can then be prepared directly from this worksheet. Note that we need to enter a $500 debit to the bottom of the income statement to balance the debit and credit columns. This is because revenues (which are credits) exceeded expenses (which are debits) by $500 resulting in a $500 net income for the period. We also need to add the $500 net income figure to the balance sheet credit column to balance its debit and credit columns. This is because Larry has increased shareholder’s equity in the business by $500 by earning a $500 profit for the month of July. Supplementary Notes – Accounting CyclPage 7 Owens Real Estate Limited Work Sheet for the month Ended July 31, 2011 Account Titles Trial Balance Adjustments Income Statement Balance Sheet Dr Cr Dr Cr Dr Cr Dr Cr Cash 42750 42750 Prepaid rent 3000 (17) 1000 2000 Office Supplies 600 600 Automobile 30000 30000 Office Equipment 12000 12000 Accounts Payable 2350 2350 Unearned Management Fees 750 (19) 250 500 Car Loan 30000 30000 Common Stock 50000 50000 Dividends 200 200 Commissions Earned 8500 8500 Office Salaries Expense 2000 2000 Telephone Expense 200 200 Gas, Oil and Repairs 250 250 Advertising Expense 600 600 91600 91600 Rent Expense (17) 1000 1000 Amortization Expense (18) 4200 4200 Accumulated Amortization -automobile (18) 3000 3000 Accumulated Amortization -office equipment (18) 1200 1200 Management Fees Earned (19) 250 250 5,450 5,450 8,250 8,750 87,550 87,050 Net Income 500 500 8,750 8,750 87,550 87,550 Supplementary Notes – Accounting CPage 8 Owens Real Estate Limited Income Statement for the month ended July 31, 2011 Revenue 8,500 Commissions Earned 250 Management Fees 8,750 Expenses Amortization Expense 4,200 Office Salaries Expense 2,000 Rent Expense 1,000 Advertising Expense 600 Gas, Oil, and Repairs 250 Telephone Expense 200 8,250 Net Income 500 Owens Real Estate Limited Retained Earnings Statement for the month ended July 31, 2011 Retained Earning - Beginning of month -0- Add: Net Income 500 Deduct: Dividends (200) Retained Earning – end of month 300 Supplementary Notes – Accounting cycle – page 9 Owens Real Estate Limited Balance Sheet July 31, 2011 Assets Current Assets Cash 42,750 Prepaid Rent 2,000 Office Supplies 600 45,350 Fixed Assets Office equipment 12,000 Less: Accumulated Amortization (1,200) 10,800 Automobile 30,000 Less: Accumulated Amortization (3,000) 27,000 37,800 Total Assets 83,150 Liabilities and Equity Liabilities Current Liabilities Accounts Payable 2,350 Unearned management fees 500 2,850 Long term liabilities Car Loan 30,000 Total Liabilities 32,850 Equity Share Capital 50,000 Deficit 300 Total equity 50,300 Total Liabilities and Equity 83,150 In order to bring the accounts up to date, the ad
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