Completing the Accounting Cycle Practice Flashcards

Overview of the Accounting Cycle

The accounting cycle is a series of steps performed during each accounting period to process business transactions and prepare financial statements. The cycle includes the following sequential actions:

• Analyze Business Transactions: Identify the economic impact of events on the accounting equation.
• Journalize: Record transactions in the general journal.
• Post: Transfer journal entries to the ledger accounts.
• Trial Balance: Prepare a list of accounts and their balances to ensure debits equal credits.
• Adjusting Entries: Record end-of-period adjustments for accruals and deferrals.
• Adjusted Trial Balance: Prepare a trial balance after adjustments are posted.
• Financial Statements: Prepare the Income Statement, Owner’s Equity Statement, and Balance Sheet.
• Closing Entries: Journalize and post entries to transfer temporary account balances to permanent equity.
• Post-Closing Trial Balance: Verify the equality of permanent account balances before the next period starts.

Using a Worksheet in the Accounting Cycle

A worksheet is a multiple-column form used as an informal tool in the preparation of financial statements.

• Nature of the Worksheet:     * It is not a permanent accounting record.     * Its use is optional but highly beneficial for managing complex adjustments.     * It follows a specific five-step process to organize data.

• Five Steps in Preparing a Worksheet:     1. Prepare a Trial Balance on the Worksheet: All accounts with balances are listed directly from the ledger accounts into the "Trial Balance" columns (Debit and Credit).     2. Enter Adjustment Data: Record the adjustments in the "Adjustments" columns. These columns are totaled and checked for equality. New account titles may be added below the trial balance if they were not previously in the ledger.         * Adjustment Keys (Examples from Pioneer Advertising Agency):             * (a) Supplies Used             * (b) Insurance Expired             * (c) Depreciation Expensed             * (d) Service Revenue Earned             * (e) Service Revenue Accrued             * (f) Interest Accrued             * (g) Salaries Accrued     3. Enter Adjusted Balances: Combine the trial balance figures with the adjustment figures to fill out the "Adjusted Trial Balance" columns. These columns are summed to ensure they remain in balance.     4. Extend Adjusted Balances to Appropriate Statement Columns:         * Revenue and expense account balances are moved to the "Income Statement" columns.         * Asset, liability, and owner’s equity balances (including drawings) are moved to the "Balance Sheet" columns.     5. Total the Statement Columns and Compute Net Income (or Net Loss): Calculate the difference between the debit and credit columns of the Income Statement.         * If credits (revenues) exceed debits (expenses), the difference is Net Income.         * If debits exceed credits, it is a Net Loss.         * The net income/loss is then entered into the Balance Sheet columns to ensure both the Income Statement and Balance Sheet sections of the worksheet balance out.

Preparing Financial Statements from the Worksheet

Financial statements are derived directly from the completed worksheet columns.

• Income Statement: Prepared using the revenue and expense columns.     * Example (Pioneer Advertising Agency):         * Service Revenue: $\$10,600$         * Total Expenses (Salaries, Supplies, Rent, Insurance, Interest, Depreciation): $\$7,740$         * Net Income: $\$2,860$
• Owner’s Equity Statement: Uses the capital and drawing accounts from the Balance Sheet columns plus the net income/loss from the Income Statement.     * Example:         * Owner’s Capital (Oct 1): $\$0$         * Add: Investments: $\$10,000$         * Add: Net income: $\$2,860$         * Less: Drawings: $\$500$         * Owner’s Capital (Oct 31): $\$12,360$
• Balance Sheet: Prepared using the asset, liability, and updated equity figures.     * Assets: Cash ($\$15,200$), Accounts Receivable ($\$200$), Advertising Supplies ($\$1,000$), Prepaid Insurance ($\$550$), Office Equipment less Accumulated Depreciation ($\$5,000 - \$40 = \$4,960$).     * Liabilities: Notes Payable ($\$5,000$), Accounts Payable ($\$2,500$), Interest Payable ($\$50$), Unearned Revenue ($\$800$), Salaries Payable ($\$1,200$).     * Owner's Equity: Capital ($\$12,360$).     * Total Assets and Total Liabilities/Equity: $\$21,910$

Closing the Books

At the end of an annual accounting period, the company must prepare accounts for the next period. Closing entries formally transfer the temporary account balances (revenues, expenses, and drawings) to the permanent owner's equity account.

• Temporary vs. Permanent Accounts:     * Temporary (Nominal) Accounts: These relate to only one accounting period. They include all Revenue accounts, Expense accounts, and the Owner’s Drawing account. They are closed (zeroed out) at the end of the period.     * Permanent (Real) Accounts: These relate to one or more future accounting periods and consist of all Balance Sheet accounts (Assets, Liabilities, and Owner’s Capital). They are not closed.

• The Closing Process:     1. Close Revenue accounts to the Income Summary account.     2. Close Expense accounts to the Income Summary account.     3. Close the Income Summary account (which now contains the net income or loss) to Owner’s Capital.     4. Close Owner’s Drawing directly to Owner’s Capital. Note: Drawing is not closed to Income Summary because it is not an expense of the business.

Post-Closing Trial Balance

The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that are carried forward into the next accounting period.

• After journalizing and posting closing entries, all temporary accounts will have zero balances.
• The post-closing trial balance will contain only the assets, liabilities, and the updated ending owner's capital account.

Correcting Entries: An Avoidable Step

Correcting entries are made whenever an error is discovered in the accounting records. Unlike adjusting entries, they are not a required part of the cycle if the records are error-free.

• Timing: They are made as soon as the error is discovered.

• Order: They must be posted before closing entries.

• Alternative Approach: Instead of a single correcting entry, the incorrect entry can be reversed entirely, and the correct entry can then be prepared.

• Case 1 (Revenue Error):     * Situation: On May 10, a $\$50$ cash collection on account was recorded as a debit to Cash $\$50$ and a credit to Service Revenue $\$50$.     * Incorrect Entry: Cash (Dr. $\$50$), Service Revenue (Cr. $\$50$).     * Correct Entry: Cash (Dr. $\$50$), Accounts Receivable (Cr. $\$50$).     * Correcting Entry: Service Revenue (Dr. $\$50$), Accounts Receivable (Cr. $\$50$).

• Case 2 (Asset and Amount Error):     * Situation: On May 18, office equipment costing $\$450$ was purchased on account, but recorded as a debit to Delivery Equipment $\$45$ and a credit to Accounts Payable $\$45$.     * Incorrect Entry: Delivery Equipment (Dr. $\$45$), Accounts Payable (Cr. $\$45$).     * Correct Entry: Office Equipment (Dr. $\$450$), Accounts Payable (Cr. $\$450$).     * Correcting Entry: Office Equipment (Dr. $\$450$), Delivery Equipment (Cr. $\$45$), Accounts Payable (Cr. $\$405$).

The Classified Balance Sheet

To improve readability and help stakeholders understand the financial health of a company, assets and liabilities are grouped into standardized classifications.

• Asset Classifications:     * Current Assets: Assets expected to be converted to cash or used up within one year or one operating cycle (the time from inventory purchase to cash collection), whichever is longer. Common order: Cash, Short-term investments, Receivables, Inventory, Prepaid expenses.     * Long-term Investments: Investments in stocks and bonds of other companies held for more than a year, or long-term assets (like land) not currently used in operations.     * Property, Plant, and Equipment (PPE): Assets with long useful lives currently used in operations. Includes land, buildings, and equipment. Accumulated Depreciation is subtracted from the cost of these assets.     * Intangible Assets: Assets without physical substance that provide value, such as goodwill, patents, and trademarks.

• Liabilities and Owner’s Equity Classifications:     * Current Liabilities: Obligations the company expects to pay within the next year. Examples include Norths Payable (usually listed first), Accounts Payable, and various accrued expenses.     * Long-term Liabilities: Obligations a company expects to pay after one year, such as long-term notes payable or bonds payable.     * Owner’s Equity:         * Proprietorship: One capital account.         * Partnership: A capital account for each partner.         * Corporation: Divided into Capital Stock and Retained Earnings.

• Key Concept - Liquidity: Liquidity refers to the company's ability to pay obligations that are due within the next year.