This article breaks down completing the accounting cycle. Pay attention to the section on adjustments, the section on closing out the accounting cycle process, and the steps involved in closing the books, which we will cover in greater detail in the next unit.
There are two methods of recording revenues and expenses in the income statement: accrual basis and cash basis. The accrual basis of accounting is a more precise method of matching revenues and expenses, and it is more widely used. It matches revenues and expenses when they are incurred rather than when cash is received or disbursed. The cash basis of accounting records revenues and expenses only when cash is received or disbursed, and this method is often not acceptable for many forms of business.
At the end of a financial period, many balances listed in the trial balance are in need of some adjustment. Common adjustments pertain to prepaid expenses, plant assets, and accrued expenses. If the proper adjusting entries are not made, financial statements will be incorrect. It is not necessary to keep track of transactions that affect revenues and expenses on a day to day basis. Adjustments should be made at the end of each accounting period.
At the end of an accounting period, adjustments must be made to reflect the portion of the asset that has been consumed during the period. The amount of asset or prepaid expense consumed is recorded as a debit to the expense account, and a credit to the asset account. Should an adjusting entry not be made, expenses, net income, owner's equity, and assets would all be overstated.
The amount of a prepaid asset to be expensed over its expected life can be expressed as:
For example, insurance was prepaid for the next four years for $ 26,000. The insurance expense for a year would be $ 6,500 ($26,000/ 4 years), or $ 541.67 per month ($26,000/48 months). The corresponding adjusting entry is:
Plant assets represent long-term tangible property owned by the firm. Although it is often not visible, the usefulness of a plant asset declines. This loss of usefulness is known as depreciation, and it requires an adjusting entry periodically. The decline in value requires a debit to Depreciation Expense account, and a credit to Accumulated Depreciation (which is said to be a contra asset account). The difference between the balances of the asset and contra asset accounts is the book value of the asset. If the adjusting entry is not made, assets, owner's equity, and net income will be overstated, and expenses will be understated.
Example: Purchased equipment for $36,000 that has an estimated life of 12 years with no residual value.
|Cost of equipment – Residual amount/ Life||= $36,000 – 0/ 12 years|
|= $ 3,000 depreciation expense per year|
|Cost of equipment – Residual amount/ Life||= $36,000 – 0/ 144 months|
|= $ 250 depreciation expense per month|
|Adjusting journal entry:|
|Depreciation expense – Equipment|
|Accumulated depreciation – Equipment|
While most expenses are prepaid, a few are paid after a service has been performed. This is the case of wages and salaries. Since the expense has not been paid but services have been received, an accrued expense and a liability have taken place. The adjusting entry requires a debit to an expense account and a credit to a liability account. Failure to do so will result in net income and owner's equity being overstated, and expenses and liabilities being understated.
Adjusting journal entry:
Employee wages $ 1,500
Management salaries 4,000
Accrued expense $ 5,500
The work sheet is a collection of important data that is used to determine which adjusting entries must be performed. It also assists in the preparation of financial statements. The first step in preparing a work sheet is the trial balance. Once a trial balance proves (i.e. total debits equal total credits), adjusting entries can be performed. To make certain all debits and credits still prove after all adjusting entries, an adjusted trial balance is created. Once the adjusted trial balance proves, it is separated into an income statement and a balance sheet. All columns of the work sheet should have equal balances for debits and credits.
The work sheet is used in the preparation of the financial statements. The results of the income statement (net profit or loss) are transferred to the statement of owner's equity. If additional funds have been invested or withdrawn over the period, such changes are recorded to the statement of owner's equity. The owner's equity account in the balance sheet is transferred from the statement of owner's equity. All other balances of the balance sheet are transferred from the work sheet balance sheet columns.
After the financial statements are completed, all adjusting entries are recorded in the journal and posted to the ledger so that all financial statements are in agreement. It is necessary to close all temporary accounts and record the net change to the owner's equity account. This is accomplished by journalizing and posting closing entries for all temporary accounts. An Income Summary account is used to summarize revenue and expense accounts, and establishing the net profit or loss for the period. In addition, any transaction that increases or decreases capital should also be posted to the appropriate capital account.
The accounting cycle begins with the analysis of all transactions and recording them in the journal. Once all transactions have been recorded in the journal, they are posted to the ledger and a trial balance is drawn. The trial balance, adjusting entries, and any additional information for the financial statements are recorded in the work sheet. After the completion of the work sheet, the financial statements are finalized. All adjusting and closing entries are then journalized and posted to the ledger. To ensure all entries were correctly made, a post-closing trial balance is prepared to show the equality of debits and credits, as well as to confirm Assets, Liabilities, and Capital accounts with proper open balances.
Source: John Petroff, https://www.peoi.org/Courses/Coursesen/ac/fram3.html
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