4 Week 4 The Accounting Cycle
Week 4 The Accounting Cycle
Introduction
Learning Objectives
By the end of this week, you will be able to create financial statements by following the accounting cycle:
- Analyze – the financial transaction
- Journalize – Record the transaction in the initial book of entry
- Post – record the joural entries in the accounts of the general ledger
- Summarize – Prepare an unadjusted trial balance.
- Adjust – Prepare adjusting entries
- Summarize – Prepare an adjusted trial balance.
- Report – Create the financial statements from the adjusted trail balance.
- Close- Complete the accounting cycle by journalizing and posting the adjusting entries.
- Summarize – Prepare a post=closing trial balance.
This chapter should take you 15-18 minutes to read.
Introduction to the accounting cycle
There are nine steps in the accounting system. These steps are a guide to preparing and presenting economic information of the organization. It is used in every organization from a small business ‘Mom & Pop’ shop to not-for profits, a governments or multinational corporations, there are only these nine steps:
1. Analyze
Review the document to determine if it represents an economic exchange for the organization. Does it represent an exchange of items with economic value? Is it an economic exchange of the organization? Determine which ‘accounts’ are affected, do they increase or decrease? Then determine if they need a debit or a credit to the account.
2. Journalize
Record the entry in the ‘General Journal’ also known as the ‘original book of entry’. The accounting journal is similar to a personal journal, in that it is a record of events in the life of the organization, kept in chronological order. The difference is that the ‘general journal’ of the accounting system records only the economic events in the life of an organization.
–Ensure you put the proper titles at the top of the document.
–List the debit accounts first
–Indent the credit account names
–Put the values in the appropriate column (debit or credit)
–Ensure that the transaction is in balance (Debits=Credits)
–Write a brief explanation under the transaction.
Here is an example of some entries in the ‘General Journal’:
|
Date |
Description |
Debit |
Credit |
|
1-Jul |
Cash |
40,000.00 |
|
|
|
A.Pallino, Capital |
|
40,000.00 |
|
|
Record the initial investment by owner |
|
|
|
|
|
|
|
|
1-Jul |
Prepaid rent |
12,000.00 |
|
|
|
Cash |
|
12,000.00 |
|
|
Paid for one year’s rent in advance. |
|
|
3. Post to the General Ledger
The ‘General Ledger’ is the record that contains all the account records showing the increases and decreases and a running balance, for each account.
Post the journal entries to the general ledger (you can utilize T-accounts for this purpose)
Ensure that proper titles are used at the top of your document
Put accounts in the order that they should appear on the trial balance, specifically:
•Current assets (in order of liquidity)
•Capital assets
•Current liabilities
•Long Term Debt
•Equity accounts
•Revenues
•Operating Expenses
•Other expenses
Complete the Leger accounts by determining the ending balance.
4. Summarize in a Trial Balance
The trial balance is a report that lists the accounts and their current balances. The accounts must be in a specific order (Same as the general ledger above): First Assets, in order of liquidity (the most liquid assets listed first), Second list the liabilities in order of what was due first, Third we list the Owner’s Equity accounts, Fourth are the Revenues, and Finally fifth the expenses are listed. The trial balance must ‘balance’, meaning the total debits must equal total credits. If it does not balance, try:
•Check your adding first in the trial balance
•If error is divisible by 2, you may have a balance listed on the wrong side
•If error is divisible by 9, you may have a transposition (eg. 714 is listed as 741)
5 Adjust
There are two accounting principles that guide the timing of revenues and expenses. Specifically:
- Revenue is recognized in the period in which it is earned. That is to say that revenue is “recognized” (recorded in the accounting records, at the time that is earned (that is when the service has been performed or the products have been provided to the customer).
- Matching principle states that expenses are matched to revenues that they generate. In other words, expenses are recorded in the accounting period in which they are used or consumed.
These rules give rise to the need to adjust some of the account balance, because sometimes the cash is paid before the revenue is earned or the expense is used, in other cases the cash comes after. There are four types of adjusting entries: Prepaid expenses, prepaid revenues, accrued revenues and accrued expenses.
Adjusting entries ensure that revenues are recognized in the period in which the services are performed, and that expenses are recognized in the period in which they are incurred. They are needed to ensure that the correct amounts of assets, liabilities and owner’s equity are reported on the balance sheet, and that the correct net income (or Loss) is recorded on the income statement.
The unadjusted trial balance may not contain up-to-date and complete data because some events are not recorded daily even though we are using interest, wages, utilities on a daily basis. Some costs are not journalized during the period because they expire with the passage of time rather than through recurring daily transactions. Some items may be unrecorded. A bill for costs incurred may not have been received by the end of the accounting period.
Adjusting entries are required every time financial statements are prepared. Each adjusting entry effects both the balance sheet and the income statement. An adjusting entry never involves cash.
Adjusting entries can be classified as either prepayments or accruals. Prepayments exist when cash has been received before the revenue has been recognised or when cash has been paid before the expense has been incurred. Prepayments are either prepaid expenses or unearned revenues. Accruals exist when revenue for services performed has not yet been recorded or collected or when an expense has been incurred but not yet recorded or paid.
6. Summarize in an Adjusted Trial Balance
The adjusted trial balance is the same as the unadjusted trial balance, with the exception that the balances in the accounts have been adjusted.
7. Prepare Financial Statements
The first financial statement to prepare is the ‘Income Statement’, the statement that lists all the revenues, then deducts the expenses to arrive at ‘Net Income, or Net Loss (if the expenses are higher than the revenues).
We then use the net income (or loss), to prepare the ‘Statement of Changes in Owner’s Equity’.
We prepare the Balance Sheet (Statement of Financial Position) using the ending owner’s equity from the previous statement (Owner’s Equity).
Finally, we prepare the Statement of Cashflows, using the income statement and balance sheet information.
8. Close the Books
At the end of the accounting year, the accounts are made ready for the next period. This is called closing the books. To close an account, the account balance must be reduced to zero. Revenue, expense and owner’s drawings accounts are temporary accounts that relate to a single accounting period. All temporary accounts are closed. Their balances will be zero after the closing entries are journalized and posted. Temporary accounts may then be used to accumulate data in the next accounting period, separate from the data of prior periods. Asset, liability, and the owner’s capital accounts (balance sheet accounts) are permanent accounts that relate to one or more future periods. They will continue to have balances that will be carried forward to the next accounting period. Permanent accounts are not closed.
9. Summarize in a post closing trial balance
Identical to the other trial balances, except it contains only ‘permanent accounts’. That is only Assets, Liabilities and Owner’s Equity accounts appear on the ‘Post Closing Trial Balance’. There are no revenue or expense accounts, because the balances have been ‘closed’, that is they are at zero.
Now take what you have learned and research some annual reports of various companies. You can utilize the links below to see some examples or go to the investor’s link in a company’s website of your choosing. In order to be sure that you are looking at the full official audited financial statements here are some tips:
You should look for the ‘Annual Report’. When you open it, it begins with the “MD&A”, the Management’s Discussion and Analysis. This is where the organization tries to highlight it’s successes and achievements. What you might see as their brag book. Skip past this section and find the Auditor’s report. The official audited financial statements follow.
