Description
Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material? Participate in follow up discussion by helping your classmates and sharing your tips for understanding materials, when possible.
The Adjusting and Closing Process
Introduction
Theoutput of the accounting process is the financial statements. Thetransactions that are entered into the accounting system are summarizedthrough the process of posting to the general ledger. The generalledger accounts are then adjusted prior to the preparation of financialstatements. The adjusting process and the three basic financialstatements?the income statement, balance sheet, and statement of owners’ equity?are examined in this module.
The Accrual Basis of Accounting
Thereare two main methods of accounting: the cash basis of accounting andthe accrual basis of accounting. Under the cash basis of accounting,revenue is recognized when cash is received, and expenses are recognizedwhen cash is paid. However, Generally Accepted Accounting Principles(GAAP) requires the use of the accrual basis of accounting for almostall companies. In accrual basis accounting, revenues are recognized whenearned, and expenses are recognized when incurred, regardless of whencash is received or paid. In other words, “accrual basis accountingmeans that transactions that change a company’s financial statements arerecorded in the periods in which the events occur” (Kimmel, Weygandt,& Kieso, 2009, p. 164).
The accrualbasis of accounting requires the application of the revenue recognitionprinciple and the matching principle. The revenue recognition principledictates the following:
1.Revenues are recognized when the company performs services or delivery of goods has occurred.
2.There is persuasive evidence of an arrangement for customer payment.
3.The price is fixed or determinable.
4.Collection is reasonably assured (Libby, Libby, and Short, 2004).
Thematching principle requires that expenses be recognized when they areincurred in generating revenue; therefore, expenses are matchedagainst the revenues that they help to generate. Because of the natureof accrual basis accounting, not all revenues and expenses that shouldbe recorded in a given period are recorded as part of the normalaccounting process, typically because cash has not changed hands. Assuch, adjustments are necessary to bring the books up to an accrualbasis of accounting.
The Adjusting Process
Theaccounting cycle includes preparing journal entries, posting theentries to the general ledger, preparing a trial balance, adjusting theaccounts to bring them in accordance with an accrual basis ofaccounting, preparing an adjusted trial balance, preparing financialstatements, and closing the books.
Adjustingentries are necessary whenever financial statements are going to beprepared in order to bring the asset, liability, revenue, and expenseaccounts into accordance with the accrual basis of accounting. Adjustingentries are made for prepayments and accruals. Prepayments existwhenever cash exchanges hands prior to goods or services beingdelivered, rendered, or used. Prepaid expenses are considered assetsuntil used and unearned revenues are liabilities until the goods aredelivered or the services rendered. Accrual entries are the originalrecording of a transaction, and accruals are necessary when cash has notyet been exchanged but revenues have been earned or expenses incurred.
Alladjusting entries affect both the balance sheet and the incomestatement, but adjusting entries never affect cash. The accountant mustidentify all of the adjustments that are necessary because the adjustingjournal entries are not naturally prepared through the normal course ofbusiness operations. To identify adjusting journal entries required forprepayments, the accountant must review the unadjusted trial balanceand search for prepaid assets, including supplies and long-termdepreciable assets, and unearned revenues that must be adjusted. Theaccountant must also find any revenues and expenses that need to beaccrued through reviewing prior period accruals and making inquiries ofmanagement.
After the adjusting entries areidentified, they must be posted to the ledger and a post-closing trialbalance must be prepared. The following summarizes the types ofadjustments that must be identified and journalized:
Preparation of the Financial Statements
Theadjusted trial balance becomes the basis for the preparation offinancial statements. Three of the financial statements?the incomestatement, statement of retained earnings, and balance sheet?areprepared, in that order, directly from the adjusted trial balance. Toprepare the fourth financial statement required by GAAP, the statementof cash flows, it is necessary to use the other three statements as wellas supplemental information.
Income Statement
Theincome statement summarizes the revenue and expense items earned orincurred for a period of time. The difference between revenues andexpenses is called the net income or the net loss. Net income existswhen revenues exceed expenses, and net loss exists when expenses exceedrevenues. The net income calculated in the income statement is used inpreparing the statement of retained earnings.
Statement of Owners’ Equity
Owners’equity is equal to assets minus liabilities; therefore, it is theresidual amount left for the owners of the company after a third party’sclaims against assets are satisfied. Owners’ equity can change basedupon activities of the owners (additional capital investments ordistributions of profits) or the activities of the company’s operations(resulting in net income or net loss). The statement of owners’ equityshows how the beginning balance became the ending balance in owners’equity. This is done by starting with the beginning balance, adding netincome or subtracting net loss, and subtracting distributions paidduring the period to get the ending balance in owners’ equity. Theending balance in owners’ equity is then used to prepare the balancesheet.
Balance Sheet
Thebalance sheet, unlike the income statement and the statement ofretained earnings, is not for a period of time, but rather for a pointin time. The balance sheet presented with a complete set of financialstatements is as of the final date in the period covered by the incomestatement. The balance sheet proves that the accounting equation is inbalance by showing that the total assets are equal to the totalliabilities plus owners’ equity. In order to make the balance sheet”balance,” the balances in the asset and liability accounts are takenoff of the adjusted trial balance, but the owners’ equity balance istaken from the ending balance in the statement of retained earnings.
Statement of Cash Flows
Thefinal financial statement prepared is the statement of cash flows. Thestatement of cash flows shows how the beginning cash balance became theending cash balance by summarizing the business’ cash inflows andoutflows into its operating activities, investing activities, andfinancing activities. The statement of cash flows will be examined infurther detail in upcoming modules.
The Closing Process
Afterthe financial statements are prepared, the books must be prepared forthe next period by closing all of the temporary accounts. All accountsare either real (permanent) or nominal (temporary). Real accounts carrytheir balances forward from period to period, while nominal accounts arethe accounts for which accountants measure only the activity of aparticular period and then start re-measuring for future periods.
Revenues,expenses, gains, and losses are all temporary accounts that aremeasured for a one-year period and then are closed to a zero balance atthe end of the year to allow for the new accumulation of income andexpense items in the following period.
Closingentries transfer net income or loss and dividends to the retainedearnings account so that the balance in retained earnings, post-closing,matches the retained earnings balance on the statement of retainedearnings for the period (Kimmel et al., 2009). To close these accounts,every revenue and gain account is debited for its exact balance, everyexpense and loss account is credited for its exact balance, and thedifference (equal to net income) is credited to the retained earningsaccount.
If a company has a net loss for theperiod, the closing entry will require a debit or decrease to retainedearnings to balance the closing entry. Dividends or other distributionsto owners are closed to retained earnings by debiting retained earningsand crediting dividends.
After the closingentries are journalized and posted to the general ledger, a post-closingtrial balance can be prepared. The post-closing trial balance will onlyhave balances for the real accounts, as all nominal accounts will havebeen closed. The only real account that should have its balance changefrom the adjusted trial balance amount is retained earnings.
Conclusion
Theaccounting cycle has now been reviewed in full; this includesjournalizing transactions, posting to the general ledger, preparing thetrial balance, adjusting the books and posting the adjusting entries,preparing financial statements, and finally closing the books. In theupcoming modules, the accounts will be examined in detail to understandthe principles that are applied to each type of account on the balancesheet.
References
Kimmel, P., Weygandt, J., & Kieso, D. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley and Sons, Inc.
Libby, R., Libby, P., & Short, D. (2004). Financial accounting (4th ed.). Boston: McGraw-Hill/Irwin
Horngrens Accounting, The Financial ChaptersRead chapters 3 and 4.http://gcumedia.com/digital-resources/pearson/2013/horngrens-accounting-the-financial-chapters-with-myaccountinglab_ebook_10e.phphe
