🧾Financial Accounting I Unit 5 – Completing the Accounting Cycle

Key Concepts and Terminology

• Accounting cycle encompasses the steps taken to record, classify, and summarize financial transactions from the beginning to the end of an accounting period
• Adjusting entries update account balances at the end of an accounting period to ensure they comply with the accrual basis of accounting
  • Examples include recording depreciation expense, accrued revenues, and accrued expenses
• Closing entries transfer the balances of temporary accounts (revenue, expense, and drawing accounts) to the owner's capital account, preparing them for the next accounting period
• Reversing entries, an optional step, are made at the beginning of a new accounting period to reverse adjusting entries made in the previous period
• Trial balance is a list of all accounts and their balances at a specific point in time, used to verify the equality of debits and credits
• Financial statements include the income statement, balance sheet, statement of owner's equity, and statement of cash flows, providing a comprehensive view of a company's financial performance and position
• Temporary accounts include revenue, expense, and drawing accounts, which are closed at the end of each accounting period
• Permanent accounts, such as assets, liabilities, and owner's equity, carry their balances forward to the next accounting period

The Accounting Cycle Overview

• The accounting cycle is a series of steps performed to record, classify, and summarize financial transactions for a specific accounting period
• Begins with analyzing and recording transactions in the general journal using the double-entry bookkeeping system
• Transactions are then posted to the general ledger, which contains individual accounts for each item on the financial statements
• At the end of the accounting period, a trial balance is prepared to ensure the total debits equal the total credits
• Adjusting entries are made to update account balances and ensure compliance with the accrual basis of accounting
• An adjusted trial balance is then prepared, incorporating the adjusting entries
• Financial statements (income statement, balance sheet, statement of owner's equity, and statement of cash flows) are created using the information from the adjusted trial balance
• Closing entries are made to transfer the balances of temporary accounts to the owner's capital account, preparing the accounts for the next accounting period
• A post-closing trial balance is prepared to verify that debits and credits remain equal after the closing process

Preparing the Adjusted Trial Balance

• The adjusted trial balance is prepared after adjusting entries are made and before financial statements are created
• Purpose is to verify that total debits still equal total credits after adjusting entries have been posted
• Adjusting entries are necessary to update account balances and ensure they comply with the accrual basis of accounting
  • Examples include recording depreciation expense, accrued revenues, accrued expenses, and prepaid expenses
• To prepare the adjusted trial balance, first record all adjusting entries in the general journal
• Post the adjusting entries to the general ledger accounts
• List all accounts and their balances in the adjusted trial balance, with debit balances in the left column and credit balances in the right column
• Total the debit and credit columns to ensure they are equal
• If the totals are not equal, review the adjusting entries and posting process to identify and correct any errors

Creating Financial Statements

• Financial statements are prepared using the information from the adjusted trial balance
• The four main financial statements are the income statement, balance sheet, statement of owner's equity, and statement of cash flows
• Income statement reports a company's revenues, expenses, and net income (or loss) for a specific period
  • Prepared using the revenue and expense account balances from the adjusted trial balance
• Balance sheet reports a company's assets, liabilities, and owner's equity at a specific point in time
  • Prepared using the asset, liability, and owner's equity account balances from the adjusted trial balance
• Statement of owner's equity shows the changes in the owner's capital account during the accounting period
  • Includes net income (or loss) from the income statement and any owner investments or withdrawals
• Statement of cash flows reports the cash inflows and outflows from operating, investing, and financing activities during the accounting period
  • Prepared using information from the adjusted trial balance and additional data about cash transactions
• Financial statements should be prepared in a specific order: income statement, statement of owner's equity, balance sheet, and statement of cash flows

Closing Temporary Accounts

• Closing entries are made at the end of an accounting period to transfer the balances of temporary accounts (revenue, expense, and drawing accounts) to the owner's capital account
• Purpose is to prepare temporary accounts for the next accounting period by resetting their balances to zero
• Closing entries are recorded in the general journal and posted to the general ledger
• Steps for closing temporary accounts:
  1. Close revenue accounts by debiting them and crediting the Income Summary account
  2. Close expense accounts by crediting them and debiting the Income Summary account
  3. Close the Income Summary account by debiting or crediting it (depending on whether there is a net income or net loss) and crediting or debiting the owner's capital account
  4. Close the drawing account by debiting the owner's capital account and crediting the drawing account
• After closing entries are posted, temporary accounts should have zero balances, while the owner's capital account balance is updated to reflect the current period's net income (or loss) and any owner transactions

Post-Closing Trial Balance

• The post-closing trial balance is prepared after closing entries are made to verify that debits and credits remain equal
• Includes only permanent accounts (assets, liabilities, and owner's equity) since temporary accounts have been closed and their balances transferred to the owner's capital account
• To prepare the post-closing trial balance, list all permanent accounts and their balances, with debit balances in the left column and credit balances in the right column
• Total the debit and credit columns to ensure they are equal
• If the totals are not equal, review the closing entries and posting process to identify and correct any errors
• The post-closing trial balance serves as a starting point for the next accounting period and ensures that the accounting equation (Assets = Liabilities + Owner's Equity) is in balance

Reversing Entries (Optional)

• Reversing entries are an optional step in the accounting cycle, made at the beginning of a new accounting period
• Purpose is to reverse adjusting entries made in the previous period, simplifying the recording of transactions in the new period
• Reversing entries are the exact opposite of the adjusting entries made in the previous period
  • For example, if an adjusting entry was made to record accrued salaries expense, the reversing entry would debit accrued salaries payable and credit salaries expense
• Reversing entries are recorded in the general journal and posted to the general ledger
• Not all adjusting entries need to be reversed; reversing entries are typically used for accrued revenues and accrued expenses
• If reversing entries are not used, transactions in the new period must be carefully analyzed to avoid double-counting revenues or expenses

Common Mistakes and How to Avoid Them

• Forgetting to record adjusting entries can lead to inaccurate financial statements
  • Maintain a checklist of common adjusting entries (e.g., depreciation, accruals, prepaid expenses) to ensure none are overlooked
• Posting entries to the wrong accounts can result in errors in the trial balance and financial statements
  • Double-check account numbers and names when posting entries to the general ledger
• Omitting transactions or recording them incorrectly can cause imbalances in the trial balance
  • Implement a system for reviewing and approving transactions before they are recorded in the general journal
• Failing to prepare financial statements in the proper order can lead to errors and inconsistencies
  • Follow the correct sequence: income statement, statement of owner's equity, balance sheet, and statement of cash flows
• Not reconciling subsidiary ledgers (e.g., accounts receivable, accounts payable) with the general ledger can result in discrepancies
  • Regularly compare subsidiary ledger totals to the corresponding general ledger account balances and investigate any differences
• Closing temporary accounts incorrectly can affect the accuracy of the post-closing trial balance and the owner's capital account
  • Use a step-by-step checklist to ensure all temporary accounts are closed in the proper order and to the correct accounts
• Reversing entries that are not needed can create confusion and additional work
  • Carefully consider which adjusting entries should be reversed and document the reasoning for each reversing entry