MEASUREMENT OF PROFIT • Cash basis – Income recorded when received – Expenses recorded when paid
• Accrual basis – Income recognised when the anticipated inflow of economic benefit can be reliably measured – Expenses when the consumption of benefits can be reliably measured 2
MEASUREMENT OF PROFIT continued • Temporary (nominal) accounts – Income statement accounts • Income • Expenses
THE ACCOUNTING CYCLE – FURTHER EXPANSION 1. Recognise and record transactions
Source documents
2. Journalise transactions
General journal
3. Post to ledger accounts
General ledger
4. Prepare unadjusted trial balance of GL
Trial balance (unadjusted)
Continued next slide
4
THE ACCOUNTING CYCLE – FURTHER EXPANSION continued 5. Determine adjusting entries and/or journalise
General journal
6. Post adjusting entries to general ledger
General ledger (accounts adjusted)
7. Prepare adjusted trial balance of GL (adjusted)
Trial balance (adjusted)
8. Prepare financial statements
work sheet
Financial statements 5
The need for adjusting entries • In some cases the period in which cash is paid or received does not coincide with period in which expense and income are recognised • Therefore, some accounts must be adjusted on the last day of the accounting period to correct recognition of income and expenses not reflected in cash receipts or payments
6
2
CLASSIFICATION OF ADJUSTING ENTRIES
Deferrals
Accruals
• Prepaid expenses • Unearned revenues
• Accrued expenses • Accrued revenues
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Prepaid expenses • Amounts paid before the benefit is consumed • Initially recorded as assets and charged to expenses in subsequent periods as consumed ASSET ACCOUNT Prepaid Expenses Initial cost Debit
EXPENSE ACCOUNT
Adjusting entry Credit
Adjusting entry Debit
cost used up, incurred or expired 8
Prepaid expenses continued Prepaid insurance • On 3 June a 24 month insurance policy purchased for $960. Initially recorded as: Jun 3 Prepaid Insurance 960 GST Outlays 96 Cash at Bank 1 056 (Purchase of a 25 mth fire and business liability insurance policy)
9
3
Prepaid expenses continued • By 30 June, the period end, we need to adjust prepaid insurance account to reflect the consumption Jun 30 Insurance Expense Prepaid Insurance (Adjusting entry to record expiration of 1 mth’s insurance)
40
Insurance Expense
Prepaid Insurance Initial cost 960
40
Adjusting entry 40
Adjusting entry 40
cost used up, incurred or expired
10
Prepaid expenses continued Office supplies • On 5 June an entry was made to record a tax invoice covering purchase of office supplies: Jun 5 Office Supplies GST Outlays Accounts Payable (Office supplies purchased on credit)
620 62
682
11
Prepaid expenses continued • By 30 June, the period end, we need to adjust office supplies account to reflect the remaining supplies of $540 (or $80 consumed) Jun 30 Office Supplies Expense Office Supplies (Adjusting entry to record supplies consumed in June)
80
Office Supplies Expense
Office Supplies Initial cost 620
80
Adjusting entry 80
Adjusting entry 80
cost used up, incurred or expired
12
4
Prepaid expenses continued Depreciation of equipment and buildings ASSET ACCOUNT Initial cost Debit CONTRA ASSET ACCOUNT Accumulated Depreciation Adjusting entry Credit
EXPENSE ACCOUNT Adjusting entry Debit
cost used up & allocated to current period
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Precollected or unearned revenue • Amounts received before service is performed LIABILITY ACCOUNT Unearned Revenue Adjusting entry Debit
INCOME ACCOUNT Revenue
Cash receipt
Adjusting entry Credit
revenue earned during the current period
14
Accrued or unrecorded expenses • Expenses consumed but not yet paid for LIABILITY ACCOUNT Expense Payable Adjusting entry Credit
EXPENSE ACCOUNT Adjusting entry Debit
expenses incurred
15
5
Accrued or unrecorded expenses continued
Accrued salaries (liability)
16
Accrued or unrecorded expenses continued
• On 22 June salaries were paid for the period of 8 June to 22 June: Jun 22 Salary Expense Cash at Bank (Salaries paid to employees)
3 800
3 800
17
Accrued or unrecorded expenses continued
• By 30 June, the period end, we need to adjust records to provide for liability since last pay day Jun 30 Salaries Expense Salaries Payable (Adjusting entry to record salaries payable from 23 June to 30 June) Salaries Payable
1 990
1 990
Salary Expense Initial salaries
Adjusting entry 1 990
Adjusting entry 1 990
earned, but not yet paid
18
6
Accrued or unrecorded expenses continued
• The liability is eliminated on 6 July when the next payment is made to employees Jul 6
Salaries Payable Salary Expense Cash at Bank (Salaries paid to employees)
1 990 1 710
3 700
19
Accrued or unrecorded expenses continued
Accrued interest (liability) • On 2 June, company took on a 20 year $120,000 8% mortgage requiring an annual payment of $6000 plus accrued interest • On 30 June, adjusting entry is made to record interest expense incurred in June: Jun 30 Interest Expense Interest Payable (Adjusting entry to record interest payable on mortgage for June)
800
800
20
Accrued or unrecorded expenses continued
Accrued electricity (liability) • The electricity provider invoices customers after the service has been provided • On 30 June, adjusting entry is made to record the estimated electricity used in June: Jun 30 Electricity Expense Electricity Account Payable (Adjusting entry to record electricity consumed in June)
210
210
21
7
Unrecorded or accrued revenue • Amounts due for services performed but not yet received ASSET ACCOUNT Accounts receivable
INCOME ACCOUNT Revenue Adjusting entry Credit
Adjusting entry Debit
revenue earned but not yet received 22
ADJUSTED TRIAL BALANCE • Reflects balances in ledger accounts after end-of-period adjusting entries • Debits must still equal credits!
23
PREPARATION OF FINANCIAL STATEMENTS • Income statement – Prepared first to determine profit or loss – Reflects entity’s performance
• Statement of changes in equity – Profit (loss) must be added to (subtracted from) equity – Shows details of movements in equity – Equity balance is reported in balance sheet
24
8
Balance sheet • Reflects entity’s financial position • Three major categories of accounts – Assets – Liabilities – Equity
• Statement users find it useful if assets and liabilities are further categorised
25
Balance sheet continued ASSETS • Current assets • Non-current assets – Investments – Property, plant and equipment – Intangible assets – Other assets
LIABILITIES • Current liabilities • Non-current or long-term liabilities
26
Balance sheet continued The operating cycle
27
9
PREPARING FINANCIAL STATEMENTS FROM THE WORKSHEET • The worksheet: – Assembles all information needed to adjust the accounts and prepare financial statements – Aids in the preparation of interim financial statements when adjusting and closing entries are not required – Contains information needed to close off profit and loss accounts for the period
28
Preparation of the worksheet 1.
2. 3. 4.
Enter ledger account titles and balances in the account title and unadjusted trial balance columns Enter the adjustments in the adjustment column Prepare an adjusted trial balance Extend adjusted balances to the financial statements columns
29
Preparation of financial statements • Use worksheet columns for: – Income statement – Balance sheet
• To prepare: – Income statement – Statement of changes in equity – Balance sheet
30
10
Preparing financial statements
31
FINANCIAL STATEMENTS AND DECISION MAKING • • • •
Has the business been profitable? Is the profit satisfactory? Is the business solvent? Is there enough cash for the day-to-day running of the business? • Is a bank overdraft facility needed? • Should more capital be invested? • Has the business been financed with too much long-term debt? 32