Chapter 4: The Accounting Cycle

Chapter Objectives

• By the end of this chapter, you should be able to:
  • Obj. 1 Describe the flow of accounting information from the unadjusted trial balance into the adjusted trial balance and financial statements.
  • Obj. 2 Prepare financial statements from adjusted account balances.
  • Obj. 3 Journalize closing entries.
  • Obj. 4 Describe the accounting cycle.
  • Obj. 5 Illustrate the accounting cycle for one period.
  • Obj. 6 Explain why the accrual basis of accounting is required by GAAP.
  • Obj. 7 Describe and illustrate the use of working capital and the current ratio in evaluating a company’s financial condition.
  • Obj. 8 Appendix 1: Describe and illustrate the end-of-period spreadsheet.
  • Obj. 9 Appendix 2: Prepare a statement of cash flows from a cash account.

Flow of Accounting Information (Learning Objective 1)

• The process of adjusting the accounts and preparing financial statements is one of the most important in accounting.
• The flow of accounting data in adjusting accounts and preparing financial statements is summarized in Exhibit 1.

Financial Statements (Learning Objective 2)

• Using the adjusted trial balance, the financial statements can be prepared.
  • The income statement
  • The statement of owner’s equity
  • The balance sheet

Income Statement

• The income statement is prepared directly from the Adjusted Trial Balance columns of the spreadsheet, beginning with fees earned.
• The expenses in the income statement are listed in order of size, beginning with the larger items.
  • Miscellaneous expense is the last item, regardless of its amount.

Statement of Owner’s Equity

• The statement of owner’s equity is prepared by entering the beginning balance for Chris Clark, Capital.
• Any additional investments by the owner during the period are entered in the Chris Clark, capital account.
• During the period, earned net income increases capital and is entered in the Chris Clark, capital account.
• The owner’s withdrawals during the period are subtracted to arrive at the ending balance of Chris Clark, Capital.

Balance Sheet

• The balance sheet is prepared directly from the Adjusted Trial Balance columns of the spreadsheet, beginning with cash.
• The asset and liability amounts are taken from the spreadsheet.
• The owner’s equity (capital) amount is taken from the statement of owner’s equity.
• The balance sheet shows subsections for assets and liabilities.
  • Such a balance sheet is a classified balance sheet.

Assets

• Assets are the rights to economic benefits owned by a business. Assets are commonly divided into two sections on the balance sheet:
  1. Current assets are cash and other assets that are expected to be converted to cash or sold or used up usually within one year or less, through the normal operations of the business.
  • Notes receivable and accounts receivable are amounts customers owe.
  1. Property, plant, and equipment may also be described as fixed assets or plant assets.
  • These assets include equipment, machinery, buildings, and land.
  • Except for land, these assets depreciate over a period of time.

Liabilities and Owner’s Equity

• Liabilities are obligations owed by a business to transfer resources to creditors. Liabilities are commonly divided into two sections on the balance sheet:
  1. Current liabilities are liabilities that will be due within a short time (usually one year or less) and that are to be paid out of current assets.
  2. Long-term liabilities are liabilities that will not be due for a long time (usually more than one year).
• The owner’s right to the assets of the business is presented on the balance sheet below the Liabilities section as Owner’s Equity.
• The owner’s equity is added to the total liabilities, and this total must be equal to the total assets.

Statement of Cash Flows

• While the income statement, statement of owner’s equity, and balance sheet can be prepared from the Adjusted Trial Balance columns, the statement of cash flows is prepared by analyzing the cash account.
• In doing so, each cash transaction is classified as an operating, investing, or financing activity.
• In practice, however, the statement of cash flows is normally prepared using a different, more complex method called the indirect method.

Knowledge Check Activity 1

• Which of the following would not be considered a current asset?
  • a. Land
  • b. Cash
  • c. Supplies
  • d. Accounts Receivable

Knowledge Check Activity 1: Answer

• Which of the following would not be considered a current asset?
  • Answer: a. Land
  • A current asset is expected to be converted to cash or sold or used up usually within one year or less, through the normal operations of the business. Land would be a long-term asset.

Closing Entries (Learning Objective 3)

• The balances of the accounts reported on the balance sheet are carried forward from year to year.
• Because they are relatively permanent, these accounts are called permanent accounts or real accounts.
  • The balances of the accounts reported on the income statement are not carried forward from year to year.
  • The balance of the owner’s drawing account, which is reported on the statement of owner’s equity, is not carried forward.
• Because these accounts report amounts for only one period, they are called temporary accounts or nominal accounts.
  • Temporary accounts are not carried forward because they relate only to one period.
• At the beginning of the next period, temporary accounts should have zero balances.
  • To achieve this, temporary account balances are transferred to permanent accounts at the end of the accounting period.
• The journal entries that transfer these balances are called closing entries.
• The transfer process is called the closing process and is sometimes referred to as closing the books.
• The closing process involves the following two steps:
  • Step 1. Revenue and expense account balances are transferred to the owner’s capital account.
  • Step 2. The balance of the owner’s drawing account is transferred to the owner’s capital account.
• The two closing journal entries required by the closing process are as follows:
  • Closing Entry (1): Debit each revenue account for its balance, credit each expense account for its balance, and credit (net income) or debit (net loss) the owner’s capital account.
  • Closing Entry (2): Debit the owner’s capital account for the balance of the owner’s drawing account and credit the owner’s drawing account for its balance.
• Closing entries are recorded in the journal and are dated as of the last day of the accounting period.

Knowledge Check Activity 2

• Which of the following would be considered a nominal account rather than a real account?
  • a. Accounts Receivable
  • b. Accounts Payable
  • c. Rent Expense
  • d. Cash

Knowledge Check Activity 2: Answer

• Which of the following would be considered a nominal account rather than a real account?
  • Answer: c. Rent Expense
  • Nominal accounts are temporary and are not carried forward because they relate only to one period. Revenue and expense account balances are transferred to the owner’s capital account through the closing process.

Accounting Cycle (Learning Objective 4)

• The accounting process that begins with analyzing and journalizing transactions and ends with the post-closing trial balance is called the accounting cycle.
• The steps in the accounting cycle are as follows:
  • Step 1. Transactions are analyzed and recorded in the journal.
  • Step 2. Transactions are posted to the ledger.
  • Step 3. An unadjusted trial balance is prepared.
  • Step 4. Adjustment data are assembled and analyzed.
  • Step 5. An optional end-of-period spreadsheet is prepared.
  • Step 6. Adjusting entries are journalized and posted to the ledger.
  • Step 7. An adjusted trial balance is prepared.
  • Step 8. Financial statements are prepared.
  • Step 9. Closing entries are journalized and posted to the ledger.
  • Step 10. A post-closing trial balance is prepared.

Discussion Activity 1

• The accounting cycle involves multiple steps including a closing process that reverses the balances of revenue and expense accounts in a closing journal entry. At times, it seems like accountants are always “closing” the books, yet they never seem to “open” them. In groups of 2‒3 students, discuss why this appears to be the case.

Discussion Activity 1 Debrief

• It is important to recall the difference between real (permanent) and nominal (temporary) accounts, as well as the functions of the balance sheet and the income statement.
  • The balance sheet is comprised of permanent accounts that are not closed in the closing process. The asset, liability, and owner’s equity accounts retain their balances from one accounting period to the next. Therefore, they are always “open.” When the balance sheet is prepared, it reflects the balances of the accounts on that particular date.
  • The income statement is comprised of temporary accounts that are reversed (closed) in the closing process to a zero balance. These accounts then begin to accumulate postings from the new accounting period’s transactions. The income statement reflects the accumulation of transactions during a specific reporting period.

Illustration of the Accounting Cycle (Learning Objective 5)

• In this section, the complete accounting cycle for one period is illustrated.
• Kelly Pitney has operated a part-time consulting business from her home.
• As of April 1, 20Y8, Kelly decided to move to rented quarters and to operate the business on a full-time basis.

Step 1. Analyzing and Recording Transactions in the Journal

• The first step in the accounting cycle is to analyze and record transactions in the journal using the double-entry accounting system.
• Transactions are analyzed and journalized as follows:
  • Step 1. Carefully read the description of the transaction to determine whether an asset, liability, owner’s equity (capital or drawing), revenue, or expense account is affected.
  • Step 2. For each account affected by the transaction, determine whether the account increases or decreases.
  • Step 3. Determine whether each increase or decrease should be recorded as a debit or a credit, following the rules of debit and credit.
  • Step 4. Record the transaction using a journal entry.
• The company’s chart of accounts is useful in determining which accounts are affected by the transaction.

Step 2. Posting Transactions to the Ledger

• Periodically, the transactions recorded in the journal are posted to the accounts in the ledger.
• The debits and credits for each journal entry are posted to the accounts in the order in which they occur in the journal.
• Journal entries are posted to the accounts using the following four steps:
  • Step 1. The date is entered in the Date column of the account.
  • Step 2. The amount is entered into the Debit or Credit column of the account.
  • Step 3. The journal page number is entered in the Posting Reference column.
  • Step 4. The account number is entered in the Posting Reference (Post. Ref.) column in the journal.
• The journal entries for Kelly Consulting have been posted to the ledger shown in Exhibit 18.

Step 3. Preparing an Unadjusted Trial Balance

• An unadjusted trial balance is prepared to determine whether any errors have been made in posting the debits and credits to the ledger.
• The unadjusted trial balance shown in Exhibit 11 does not provide complete proof of the accuracy of the ledger.
• It indicates only that the debits and the credits are equal.
• This proof is of value, however, because errors often affect the equality of debits and credits.
• If the two totals of a trial balance are not equal, an error has occurred that must be discovered and corrected.

Step 4. Assembling and Analyzing Adjustment Data

• Before the financial statements can be prepared, the accounts must be updated.
• The four types of accounts that normally require adjustment include accrued revenues, accrued expenses, unearned revenues, and prepaid expenses.
• In addition, depreciation expense must be recorded for fixed assets other than land.
• The following data have been assembled on April 30, 20Y8, for analysis of possible adjustments for Kelly Consulting:
  • a. Insurance expired during April is $300.
  • b. Supplies on hand on April 30 are $1,350.
  • c. Depreciation of office equipment for April is $330.
  • d. Accrued receptionist salary on April 30 is $120.
  • e. Rent expired during April is $1,600.
  • f. Unearned fees on April 30 are $2,500.

Step 5. Preparing an Optional End-of-Period Spreadsheet

• Although an end-of-period spreadsheet is not required, it is useful in showing the flow of accounting information from the unadjusted trial balance to the adjusted trial balance.
• In addition, an end-of-period spreadsheet is useful in analyzing the impact of proposed adjustments on the financial statements.
• The end-of-period spreadsheet for Kelly Consulting is shown in Exhibit 12.

Step 6. Journalizing and Posting Adjusting Entries

• Based on the adjustment data shown in Step 4, adjusting entries for Kelly Consulting are prepared as shown in Exhibit 13.
• Each adjusting entry affects at least one income statement account and one balance sheet account.
  • Explanations for each adjustment, including any computations, may be included with each adjusting entry.
• Each of the adjusting entries is posted to Kelly Consulting’s ledger shown in Exhibit 18.
• The adjusting entries are identified in the ledger as “Adjusting.”

Step 7. Preparing an Adjusted Trial Balance

• After the adjustments have been journalized and posted, an adjusted trial balance is prepared to verify the equality of the total of the debit and credit balances.
• This is the last step before preparing the financial statements.
• If the adjusted trial balance does not balance, an error has occurred and must be found and corrected.
• The adjusted trial balance for Kelly Consulting as of April 30, 20Y8, is shown in Exhibit 14.

Step 8. Preparing the Financial Statements

• The most important outcome of the accounting cycle is the financial statements.
• The income statement is prepared first, followed by the statement of owner’s equity and then the balance sheet.
  • The statements can be prepared directly from the adjusted trial balance, the end-of-period spreadsheet, or the ledger.
• The net income or net loss shown on the income statement is reported on the statement of owner’s equity along with any additional investments by the owner and any owner withdrawals.
• The ending owner’s capital is then reported on the balance sheet and is added with total liabilities to equal total assets.

Step 9. Journalizing and Posting Closing Entries

• The two closing entries for Kelly Consulting are shown in Exhibit 16.
• After the closing entries are posted, Kelly Consulting’s ledger has the following characteristics:
  • The balance of Kelly Pitney, Capital of $42,300 agrees with the amount reported on the statement of owner’s equity and the balance sheet.
  • The revenue, expense, and owner’s drawing accounts will have zero balances.
• The closing entries are normally identified in the ledger as “Closing.”
• In addition, a line is often inserted in both balance columns after a closing entry is posted.
  • This separates next period’s revenue, expense, and dividend transactions from those of the current period.

Step 10. Preparing a Post-Closing Trial Balance

• A post-closing trial balance is prepared after the closing entries have been posted.
• The purpose of the post-closing trial balance is to verify that the ledger is in balance at the beginning of the next period.
• The accounts and amounts in the post-closing trial balance should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period.
• The balances shown in the post-closing trial balance are taken from the ending balances in the ledger shown in Exhibit 18.

Knowledge Check Activity 3

• Which of the following accounts would not be listed on the post-closing trial balance?
  • a. Office Equipment
  • b. Cash
  • c. Unearned Fees
  • d. Fees Earned

Knowledge Check Activity 3: Answer

• Which of the following accounts would not be listed on the post-closing trial balance?
  • Answer: d. Fees Earned
  • The post-closing trial balance should only list the balance sheet accounts, which are the permanent accounts that retain their balances from one accounting period to the next. Fees Earned is a revenue account that is closed out to owner’s equity in the closing entry.

Why Is the Accrual Basis of Accounting Required by GAAP? (Learning Objective 6)

• To understand why the accrual basis of accounting is required, it is first necessary to consider the alternative.
• The primary alternative to GAAP is the cash basis of accounting, which records transactions only when cash is received or paid.
• The accrual basis of accounting uses the revenue and expense recognition principles to record revenues and expenses.
  • Under the revenue recognition principle, revenues are recorded when earned, which is when the services have been performed or products have been delivered to customers.
  • Under the expense recognition principle, the expenses incurred in generating revenue are recorded in the same period as the related revenue.
  • To ensure that revenues and expenses are properly matched, adjusting entries are recorded at the end of the accounting period.

Discussion Activity 2

• The accounting profession subscribes to the rules of generally accepted accounting principles (GAAP). But who develops and revises these rules for accountants to follow? Working in teams of 2‒3 students, go online to search for an organization that is responsible for creating and maintaining GAAP. Discuss your answer with the class, and state if the result is what you expected to find.

Discussion Activity 2 Debrief

• Many people think the Securities and Exchange Commission (SEC) is responsible for determining the accounting rules that are part of GAAP. However, the SEC delegated this responsibility to an organization called the Financial Accounting Standards Board (FASB). Ultimately, the SEC can override or provide guidance to the standards determined by the FASB, but it uses this oversight sparingly. Did your online search lead to the SEC or FASB websites? If you viewed the websites’ content, share your perspectives with the class.

Analysis for Decision Making: Working Capital and Current Ratio (Learning Objective 7)

• The ability to convert assets into cash is called liquidity, while the ability of a business to pay its debts is called solvency.
• Two financial measures for evaluating a business’s short-term liquidity and solvency are working capital and the current ratio.
• Working capital is the excess of the current assets of a business over its current liabilities:
  • Working Capital = Current Assets – Current Liabilities
• Current assets are more liquid than long-term assets, because they can be more readily turned into cash to meet short-term obligations.
• Thus, an increase in a company’s current assets increases or improves its liquidity because these assets are available for uses other than paying current liabilities.
• A positive working capital implies that the business is able to pay its current liabilities and is solvent.
• Thus, an increase in working capital increases or improves a company’s short-term solvency.
• To illustrate, NetSolutions’ working capital at the end of 20Y3 is $6,355, computed as follows:
  Working Capital = Current Assets – Current Liabilities = $7,745 – $1,390 = $6,355
• The current ratio is another means of expressing the relationship between current assets and current liabilities.
• The current ratio is computed by dividing current assets by current liabilities:
  $Current Ratio = \frac{Current Assets}{Current Liabilities}$
• To illustrate, the current ratio for NetSolutions on December 31, 20Y3, is 5.6, computed as follows:
  Current Ratio = \frac{$7,745}{$1,390} = 5.6
• The current ratio is more useful than working capital in making comparisons across companies or with industry averages.