This chapter covers the accounting cycle, including debits and credits, journalizing entries, adjusting entries, closing entries, trial balance and reversing entries.
Basic Accounting Terms and Concepts
Double-Entry Accounting System: Debits and Credits
Journalizing, Posting, and Trial Balance
Adjusting Entries: Deferrals and Accruals
Preparing Financial Statements
Preparing Closing Entries | Post-Closing Trial Balance
Financial Statements for Merchandising Company
Converting Cash-Basis to Accrual-Basis Accounting
Reversing Entries|Accruals and Deferrals
Examples: BE 3-1 to BE 3-6|Basic & Adjusting Journal Entries
Examples: BE 3-7 to BE 3-9|Basic & Adjusting Entries
Examples: BE 3-10 to BE 3-11| Closing Entries
Chapter 3 presents a concise yet thorough review of the accounting process. The basic elements of the accounting process are identified and explained, and the way in which these elements are combined in completing the accounting cycle is described.
Accounting Information System
The accounting information system collects and processes transaction data and then disseminates the financial information to interested parties. To understand the accounting process, one must be aware of the basic terminology employed in the process. The basic terminology includes: event, transaction, account, real accounts, nominal accounts, ledger, journal, posting, trial balance, adjusting entries, financial statements, and closing entries. These terms refer to the various activities that make up the accounting cycle.
Double-entry accounting refers to the process used in recording transactions. The terms debit and credit are used in the accounting process to indicate the effect
a transaction has on account balances. The debit side of any account is the left side; the right side is the credit side. Assets and expenses are increased by debits and decreased by credits. Liabilities, stockholders’ equity, and revenues are decreased by debits and increased by credits.
In a double-entry system, for every debit there must be a credit and vice-versa. This leads us to the basic accounting equation: Assets = Liabilities + Stockholders’ Equity.
The Accounting Cycle
The first step in the accounting cycle is analysis of transactions and selected other events. The purpose of this analysis is to determine which events represent transactions that should be recorded.
Events can be classified as external or internal. External events are those between an entity and its environment, whereas internal events relate to transactions totally within an entity.
Transactions are initially recorded in a journal, sometimes referred to as the book of original entry. A general journal is merely a chronological listing of transactions expressed in terms of debits and credits to particular accounts. No distinction is made in
a general journal concerning the type of transaction involved. In addition to a general journal, specialized journals are used to accumulate transactions possessing common characteristics.
The next step in the accounting cycle involves transferring amounts entered in the journal to the general ledger. The ledger is a book that usually contains a separate page for each account. Transferring amounts from a journal to the ledger is called posting. Transactions recorded in a general journal must be posted individually, whereas entries made in specialized journals are generally posted by columnar total.
The next step in the accounting cycle is the preparation of a trial balance. A trial balance is a list of accounts and their balances at a given time. An entity may prepare a trial balance at any time in the accounting cycle. A trial balance prepared after posting has been completed serves to check the mechanical accuracy of the posting process and provides a listing of accounts to be used in preparing financial statements.
Preparation of adjusting journal entries is the next step in the accounting cycle. Adjusting entries are entries made at the end of accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared. Adjusting entries are necessary to achieve a proper matching of revenues and expenses in the determination of net income for the current period and to achieve an accurate statement of the assets and equities existing at the end of the period. One common characteristic of adjusting entries is that they affect at least one real account (asset or liability account) and one nominal account (revenue or expense account). Adjusting entries can be classified as: (1) deferrals (prepaid expenses, unearned revenues), or (2) accruals (accrued revenues, accrued expenses)
Prepaid expenses and unearned revenues refer to situations where cash has been paid or received but the corresponding expense or revenue will not be recognized until a future period. Accrued revenues and accrued expenses are revenues and expenses recognized in the current period for which the corresponding payment or receipt of cash is to occur in a future period.
Adjusted Trial Balance
After adjusting entries are recorded and posted, an adjusted trial balance is prepared. It shows the balance of all accounts at the end of the accounting period.
From the adjusted trial balance, a company can directly prepare its financial statements.
After financial statements have been prepared, nominal (revenue and expense) accounts should be reduced to zero in preparation for recording the transactions of the next period. This closing process requires recording and posting of closing entries. All nominal accounts are reduced to zero by closing them through the Income Summary account. The net balance in the Income Summary account is equal to net income or net loss for the period. The net income or net loss for the period is transferred to an owners’ equity account by closing the Income Summary account to Retained Earnings.
Post-Closing Trial Balance
A third trial balance may be prepared after the closing entries are recorded and posted. This post-closing trial balance shows that equal debits and credits have been posted properly to the Income Summary account.
Reversing entries are made at the beginning of an accounting period to remove the effects of some adjusting entries. They are optional.
Accounting Cycle Summarized
In summary, the steps in the accounting cycle performed every fiscal period are as follows:
- Enter the transactions of the period in appropriate journals.
- Post from the journals to the ledger (or ledgers).
- Take an unadjusted trial balance (trial balance).
- Prepare adjusting journal entries and post to the ledger(s).
- Take a trial balance after adjusting (adjusted trial balance).
- Prepare the financial statements from the adjusted trial balance.
- Prepare closing journal entries and post to the ledger(s).
- Take a trial balance after closing (post-closing trial balance).
- Prepare reversing entries (optional) and post to the ledger(s).
Financial Statements for a Merchandising Company
The income statement classifies amounts into such categories as gross profit, income from operations, income before taxes, and net income. The statement of retained earnings shows the changes in retained earnings during the period. A classified balance sheet classifies assets and liabilities into current and noncurrent.
Closing entries of a merchandising company require that the Cost of Goods Sold account be closed along with the other expense accounts.
Cash Versus Accrual-Basis Accounting
Cash-Basis Accounting Versus Accrual-Basis Accounting is presented in Appendix A of Chapter 3 for the purpose of demonstrating the difference between cash basis and accrual-basis accounting. Under the strict cash basis of accounting, revenue
is recognized only when cash is received, and expenses are recorded only when cash is paid. The accrual basis of accounting recognizes revenue when it is earned and expenses when incurred without regard to the time of receipt or payment of cash.
Appendix B covers preparation and posting of reversing entries, the final step in the accounting cycle. A reversing entry is made at the beginning of the next accounting period and is the exact opposite of the adjusting entry made in the previous period. The recording of reversing entries is an optional step in the accounting cycle that may be performed at the beginning of the next accounting period. The entries subject to reversal are the adjusting entries for accrued revenues and accrued expenses recorded at the close of the previous accounting period.
Appendix C covers the use of a 10-column worksheet, which serves as an aid to the accountant in adjusting the account balances and preparing the financial statements. The worksheet provides an orderly format for the accumulation of information necessary for preparation of financial statements. Use of a worksheet does not replace any financial statements, nor does it alter any of the steps in the accounting cycle.