Completing The Accounting Cycle Notes

Completing the Accounting Cycle

Learning Objectives

• Describe all the steps in the complete accounting cycle.
• Explain why temporary ledger accounts need to be closed.
• Explain how to record adjusting entries from the worksheet.
• Describe the closing process, enter closing entries in accounting records, and prepare a post-closing trial balance.
• Account for accrual items in subsequent periods using reversing entries.
• Prepare the equity accounts for a partnership and for a company.

Complete Accounting Cycle

1. Recognize and record transactions using source documents and the general journal.
2. Journalize transactions.
3. Post to ledger accounts in the general ledger.
4. Prepare an unadjusted trial balance from the general ledger.
5. Determine adjusting entries and journalize them in the general journal.
6. Post adjusting entries to the general ledger, resulting in adjusted accounts.
7. Prepare an adjusted trial balance.
8. Journalize closing entries in the general journal.
9. Post closing entries to the general ledger, closing temporary accounts.
10. Prepare a post-closing trial balance.
11. Prepare financial statements, using a worksheet.
12. Journalize reversing entries in the general journal.
13. Post reversing entries to the general ledger.

Closing Temporary Accounts

• Income and expense accounts must be reduced to zero at the end of each period to determine the profit or loss for the period.
• These reductions are accomplished through closing entries.
• After closing, income and expense accounts begin the next accounting period with a zero balance. The Profit or Loss Summary account summarizes balances and calculates profit.
• Balance sheet accounts are not closed.

Using the Worksheet to Record Adjusting Entries

• The worksheet gathers information in one place, serving as a "one-stop shop."
• It enables fast preparation of interim statements.
• Adjusting entries are easily reflected on the worksheet, facilitating closing journal preparation.

Recording Adjusting Entries

• Formal adjusting entries may be entered in the general journal from the worksheet.
• Entries are dated the last day of the accounting period.
• Data for determining the entity’s closing entries for the period are found in the income statement columns of the worksheet, which contain temporary income and expense accounts.

The Closing Process

1. Income accounts are closed to the Profit or Loss (P or L) Summary account:
   • Debit income accounts.
   • Credit P or L Summary.
2. Expense accounts are closed to the P or L Summary account:
   • Debit P or L Summary.
   • Credit expense accounts.
3. The Profit or Loss Summary balance (representing profit or loss) is then closed to the capital account:
   • Debit P or L Summary (assuming a profit).
   • Credit capital account.
4. Drawings are closed to the capital account:
   • Debit capital account.
   • Credit drawings account.

Example of Closing Process

• Profit or Loss Summary
  Expense: $14,940$
  Closing Entry: $5,560$
  Income: $20,500$
• Income
  Closing Entry: $20,500$
  Total: $20,500$
• Expenses
  Total: $14,940$
  Closing Entry: $14,940$
• Drawings
  Balance: $1,200$
  Closing Entry: $1,200$
• Capital
  Balance: $240,000$
  Close Entry (Profit): $5,560$
  Closing Entry: $1,200$
  Balance Forward: $244,360$

Account Balances After the Closing Process

• All income accounts have nil balances.
• All expense accounts have nil balances.
• The drawings account has a nil balance.
• The capital account has either been:
  • Increased by the profit or
  • Decreased by the loss.
• Decreased by the drawings.
• The Capital balance is now updated.

The Post-Closing Trial Balance

• Prepared to verify the equality of debits and credits, ensuring the ledger is "in balance."
• Confirms that only permanent accounts have balances.
• Serves as the starting point for the next accounting period.

Accrual Entries in Subsequent Periods

• Adjusting entries are made at the end of the accounting period to record accruals.
• Cash received or paid in subsequent periods for accruals must be analyzed to correctly apportion the amount between the two periods.
  • Example: payment for salaries.

Example of Accrual Entries

• Original Adjusting Entry:
  • June 30: Salaries Expense $3,980$, Salaries Payable $3,980$ (Adjusting entry for salaries payable).
• Subsequent Entry:
  • July 6: Salaries Payable $3,980$, Salaries Expense $3,420$, Cash at Bank $7,400$ (Payment of salaries earned June 23 to July 6). The balance is cleared by payment.

Reversing Entries

• An alternative treatment to the previous method.
• Dated the first day of the subsequent accounting period.
• Exactly reverse certain adjusting entries.
• An accounting technique used to simplify the recording of regular transactions in the next period.
• They are optional in an accounting system but can be very useful.

Example of Reversing Entries

• Adjusting Entry:
  • June 30: Salaries Expense $3,980$, Salaries Payable $3,980$ (Adjusting entry for salaries payable).
• Reversing Entry:
  • July 1: Salaries Payable $3,980$, Salaries Expense $3,980$ (Reversing entry for salaries payable).
• Subsequent Entry:
  • July 6: Salaries Expense $7,400$, Cash at Bank $7,400$ (Payment of salaries earned June 23 to July 6).
• Effect on Salaries Expense:
  • Adjusting Entry: $3,980$
  • Closing Entry: $3,980$
  • Subsequent Entry: $7,400$
  • Reversing Entry: $3,980$
  • Correct expense recorded in prior period and closed. Correct expense recorded in current period without needing to know what had been accrued previously.

Situations for Reversing Entries

• Not required for all adjusting entries.
• Used to simplify the recording of transactions in future periods.
• Only used where the adjustment is temporary.
  • Accrued expenses.
  • Accrued income.
  • Prepayments originally recorded as expenses.
  • Unearned income originally recorded as income.

Accounting for a Partnership

• Similar in most respects to accounting for a sole trader.
• Separate capital and drawings accounts for each partner.
• Profit/loss at the end of the period is allocated to each partner in accordance with the partnership agreement.
• Each drawings account is closed off to the partner’s capital account.

Accounting for a Company

• Some key conceptual/terminology differences:
  • A company is a separate legal entity (unlike a sole trader and partnership).
  • Owners are referred to as shareholders.
  • Owners’ interests are called share capital.
  • Not all profits/losses are distributed to shareholders; they may be retained/accumulated.
  • Share capital represents retained profits (or accumulated losses) + share of assets.
• Profits are distributed as dividends.

Example: Intellect Management Services LTD - Statement of Changes in Equity

• For the year ended 31 December 2013:
  • Share Capital, 1 January 2013: $240,000$
  • Share Capital, 31 December 2013: $240,000$
  • Retained Earnings, 1 January 2013: $0$
  • Add: Profit for the year: $50,000$
  • Less: Cash dividends for the year: $24,000$
  • Retained Earnings, 31 December 2013: $26,000$

Example: Intellect Management Services LTD - Balance Sheet (extract)

• As at 31 December 2013:
  • Equity:
    • Share Capital (240,000 shares issued for $1): $240,000$
    • Retained Earnings: $26,000$
    • Total equity: $266,000$