Accounting Cycle Study Notes

Accounting Cycle

Introduction to Accounting Cycle

• The accounting cycle is a systematic process that outlines the steps to record financial transactions and prepare financial statements.
• It consists of multiple stages including adjustments and reporting, ensuring an accurate financial depiction of a business.

Lessons Learned

• Lesson 1: The accounting information system serves as a communication tool to inform stakeholders about a business's financial position.
• Lesson 2: GAAP (Generally Accepted Accounting Principles) promotes accrual accounting; cash transfer is not the sole indicator of an economic event.
• Lesson 3: The accounting cycle includes eight steps, with several dedicated to adjusting journal entries (AJEs).

Adjusting Journal Entries (AJEs)

• AJEs are necessary for recognizing economic events that have occurred but have either not been recorded in the accounting records or haven't been aligned with their corresponding cash flows.
• Comprehension of AJEs is rooted in GAAP principles.
  • Recording transactions solely based on cash transfer would render an accounting information system nearly redundant.
  • Economic events transpire independent of cash flows, exemplified by prepaid memberships.
• The Financial Accounting Standards Board (FASB) created GAAP principles for recognizing, measuring, and recording economic events, facilitating stakeholder reporting.

Fundamental Principles: Revenue and Expenses

Revenue Recognition Principle

• Definition: Revenue should be recognized in the period it is earned.
• Some revenue-earning events occur over time, spanning multiple accounting periods.
• Time passage may necessitate recognition, as seen with interest on savings accounts.
• Contracts often complicate the timing of revenue recognition.

Matching Principle

• Definition: Expenses must be matched to the revenues they help to generate.
• If revenue recognition occurs in a certain period, expenses incurred to earn that revenue must also be reported in that same period.
  • Example: Cost of goods sold.

Accounting Lexicon

• Debit: Left side of an account.
• Credit: Right side of an account.

Summary of Guidelines

• Revenue is recognized when earned.
• Expenses are recognized when incurred.

Accruals vs. Deferrals

Accrual Accounting

• Recognizes economic events before cash transactions.

Types of Accruals

1. Accruals: Events before cash flow or cash after the event.
2. Deferrals: Cash received before the event or events recorded after cash flow.

Quick Reference Chart: Accruals and Deferrals

Steps in the Accounting Cycle

1. Unadjusted Trial Balance: Preparation of this document ensures all transactions have been initially recorded.
2. Recording Adjusting Entries: Journalize and post adjustments relating to accrued or deferred items.
3. Adjusted Trial Balance: Present final balances after adjustments are made, ensuring the accounting equation remains balanced.

Types of Adjusting Entries Needed

• Record unrecorded but earned revenues (accrued revenues).
• Record unrecorded but incurred expenses (accrued expenses).
• Split unearned revenue between periods (deferred revenues).
• Divide prepaid but not yet incurred expenses between periods (deferred expenses).

Examples of Accruals and Deferrals

Accrued Revenue Example

• Institution: Osbourne Consulting hired by a car dealership for network security.
  • Monthly fee: $500, payments start next month (April 15).
  • Entry for March 31:
  • Debit Accounts Receivable: $250
  • Credit Service Revenue: $250

Accrued Expense Example

• Consulting paid $550 monthly on the 15th for prior month’s work.
  • Entry for March 31:
  • Debit Operating Expenses: $550
  • Credit Service Expenses Payable: $550

Deferred Revenue Example

• Local real estate agency pays $450 for consulting services on March 21.
  • Entry:
  • Debit Cash: $450
  • Credit Unearned Service Revenue: $450
  • Revenue recognized after services performed on March 31.

Deferred Expense Example

• Prepaying three months of office rent totaling $3,000, monthly rent is $1,000.
  • Entry for March 31:
  • Debit Rent Expense: $1,000
  • Credit Prepaid Rent: $1,000

Supplies and Depreciation

Supplies Accounting

• Usage determines expenses recorded.
• Tally supplies at end of month by subtracting remaining balance from total initial balance plus purchases to determine expenses incurred.
  • Example:
  • Beginning balance: $700; additional purchases: $200.
  • Entry Example:
  • Debit Supplies Expense: $300
  • Credit Supplies: $300

Depreciation Accounting

• Long-term assets such as furniture and equipment are recorded but lose value over time through decay or obsolescence.
• Captures the loss of value through estimates based on useful life.

Formula for Depreciation Expense:

$(Depreciation \, Expense = Cost - Salvage \, Value \times Useful \, Life)$
Example Calculation for Equipment:
$(Depreciation \, Expense = \$12,600 - \$0 \times 3 \text{ years} = \$4,200)$

Adjusted Trial Balance Overview

• Final account balances after adjustments are made should continue to balance, confirming the accuracy of all recorded transactions.

Additional Principle: Materiality

• Definition: The Materiality principle allows accountants to record and report only events of reasonable importance.
• Explains that not all minor expenditures need meticulous tracking if they do not affect decision-making by stakeholders.
• Importance is subjective, denoting that a reasonable person would consider significance in financial reporting.