Accounting Notes

The Importance of Adjusting Accounts and Financial Statements

  • Adjusting accounts and financial statements is a critical process in accounting.
  • Adjusted financial information flows into financial statements as follows:
    • Revenue and expense accounts flow into the income statement.
    • Owner's capital account and owner's drawing account, along with net income, flow into the statement of owner's equity.
    • Asset, liability accounts, and ending owner's equity flow into the balance sheet.

The Income Statement

  • The income statement is prepared directly from the adjusted trial balance columns.
  • Involves:
    • Revenues:
      • Fees earned
      • Rent revenue
      • Interest revenue
      • [Examples of revenues]
    • Expenses:
      • Wages expense
      • Supplies expense
      • Rent expense
      • [Examples of expenses]
    • Expenses are typically listed in order of size, from largest to smallest.
    • Miscellaneous expense is usually listed last, regardless of its size.

The Statement of Owner's Equity

  • The statement of owner's equity includes:
    • The balance of the owner's capital account at the beginning of the period.
    • Tracks:
      • Investments made by the owner.
      • Withdrawals taken by the owner.
      • Net income (or losses) generated by the business.
  • Example Calculation of Owner's Equity:
    • Beginning capital balance on 01/01/2018: $100,000.
    • Investment on January 1, 2018: $50,000.
    • Net income for 2018: $10,000.
    • Withdrawals during 2018: $5,000.
    • Calculation of total increase in owner's equity:
      • Owner's Equity Increase = Investment + Net Income - Withdrawals
      • Total Increase = $50,000 + $10,000 - $5,000 = $55,000.
    • Ending owner's equity on 12/31/2018:
      • Ending Balance = Initial Capital + Increase = $100,000 + $55,000 = $155,000.
  • Formula:
    • Ending Owner's Capital = Beginning Owner's Capital + Investments + Net Income - Withdrawals.

The Balance Sheet

  • Represents the Accounting Equation:
    Assets = Liabilities + Owner's Equity.
  • Assets:
    • Commonly divided into:
      • Current assets (e.g., cash, inventory): expected to be converted to cash or used within one year.
      • Property, Plant, and Equipment (fixed assets, e.g., machinery, buildings): land is permanent but not depreciating.
  • Liabilities:
    • Divided into current liabilities and long-term liabilities (e.g., mortgages).
  • Owner's equity is added to liabilities, equaling total assets, affirming the accounting equation.

Closing Entries

  • Closing entries are made after financial statements to zero out temporary accounts.
  • Types of Accounts:
    • Permanent (Real) Accounts:
      • Carried forward from period to period (balance sheet accounts).
      • Example: Cash account balance continues from year to year.
    • Temporary (Nominal) Accounts:
      • Report amounts for only one period (usually income statement accounts).
      • Reset to $0 at the beginning of the next period.
  • Closing Entries Process:
    • First Closing Entry:
      • Transfer balances of revenue and expense accounts to the owner's capital account:
      • Debit each revenue account (to make them zero).
      • Credit each expense account (to make them zero).
      • If there is net income, credit the owner's capital account; if net loss, debit the owner's capital account.
    • Second Closing Entry:
      • Transfer balance of the owner's drawing account to the owner's capital account:
      • Credit the drawing account to make it zero.
      • Debit the owner's capital account by the same amount.

The Accounting Cycle

  • The overall process includes:
    1. Analyzing transactions and recording them in the journal.
    2. Posting transactions to the ledger.
    3. Preparing an unadjusted trial balance.
    4. Assembling and analyzing adjustment data.
    5. Journalizing and posting adjusting entries.
    6. Preparing an adjusted trial balance.
    7. Preparing financial statements.
    8. Journalizing and posting closing entries.
    9. Preparing a post-close trial balance, which should verify that permanent accounts are in balance.

Fiscal Year Definition

  • A fiscal year is the annual accounting period used by a business, starting on the first day of the first month selected and ending on the last day of the following twelve months.
  • The most commonly used fiscal year aligns with the calendar year.
  • Natural Business Year: Ends when business activity reaches its lowest point in the annual operating cycle (e.g., retail stores concluding after the holiday season).

Questions and Practice Problems

  • Identify Account Types:
    • Nominal Accounts:
      • Include income statement accounts and the owner's drawing account.
    • Permanent Accounts:
      • Include balance sheet accounts, such as cash, prepaid insurance, equipment, etc.
  • Example identification question analyzed:
    • Revenue accounts (Interest revenue, Fees earned, Miscellaneous expense) are identified as nominal accounts in context.

Key Takeaways

  • Understand the process of adjusting accounts and preparing financial statements.
  • Importance of correctly classifying accounts as permanent or temporary for effective financial reporting.
  • Familiarity with the accounting cycle enhances understanding of financial processes and reporting.