Financial Accounting

Module 4: Completing the Accounting Cycle

Module Learning Outcomes

Describe the complete accounting cycle

4.1: Describe the process of making adjusting journal entries

4.2: Create adjusting journal entries
4.3: Creating the adjusted trial balance
4.4:
Use an adjusted trial balance to prepare financial statements
4.5: Prepare and post closing entries
The Adjusting Process
Learning Outcomes: The Adjusting Process

4.1: Describe the process of making adjusting journal entries

4.1.1: Explain the need for adjusting journal entries
4.1.2: Describe the adjustment process
4.1.3: Differentiate between deferrals and accruals
The Need for Adjusting Journal Entries

• Adjusting entries are made during the accounting cycle after the
unadjusted trial balance and before the company prepares its financial
statements, bringing the amounts in the general ledger accounts to their
proper balances.
• Each adjusting entry has a dual purpose:
1. To make the income statement report the appropriate revenue or expense
2. To make the balance sheet report the appropriate asset or liability
Three Adjusting Entry Rules

• Rule 1: Adjusting entries will almost never include cash.

• The purpose of adjusting entries is to make the accounting records accurately
reflect the matching principle—match revenue and expense of the operating
period. There are some rare cases where cash needs to be adjusted, but ideally,
that adjusting should have all been done prior to running the unadjusted trial
balance.
• Rule 2: Debits always equal credits (as usual).
• Rule 3: The adjusting entry will have one balance sheet account (asset,
liability, or equity) and one income statement account (revenue or
expense) in the journal entry.
• Remember, the goal of the adjusting entry is to match the revenue and expense
of the accounting period. Adjusting entries between balance sheet accounts only,
or between income statement accounts only, are usually called reclassifications.
How the Adjustment Process Works

• Accountants have followed these

steps for 500 years:
• Print out the unadjusted trial balance
• Analyze each account
• Look for anything that is missing
• Make adjusting journal entries
• Post the adjusting journal entries
Accruals versus Deferrals

• The word “accrue” means to add to. The word “defer” means to put off
until later.
• In accounting:
• If you earn revenue before you collect the cash, you have to accrue the revenue
(add it to the books).
• If you get the cash before you earn the revenue, you must defer recognition of
the revenue.
• The same holds true for expenses.
Practice Question 1

Jack is just learning about how to adjust journal entries. He is asking you
about the rules associated with the journal adjustments. What is one of the
rules of adjusting journal entries you could tell Jack?

A. Debits are always less that Credits

B. One income statement account and one balance sheet account is in
an entry
C. Adjusting entries usually include Cash
D. Adjusting entries include notes and disclosures like with financial
statements
Creating Adjusting Journal Entries
Learning Outcomes: Creating Adjusting Journal
Entries
4.2: Create adjusting journal entries
4.2.1: Analyzing revenue accounts and creating necessary adjustments
4.2.2: Analyzing expense accounts and creating necessary adjustments
4.2.3: Finding errors and creating adjustments
Analyzing Revenue Accounts and Creating
Necessary Adjustments
An asset/revenue adjustment may occur when a company performs a
service for a customer but has not yet billed the customer. The accountant
records this transaction as an asset in the form of a receivable and as
revenue because the company has earned a revenue.

JOURNAL Page 101

Date Description P.R. Debit Credit
20–
Dec. 5,000.0
Accounts Receivable
31 0
Service Revenue 5,000.00
To accrue revenue earned but not yet billed.
Analyzing Expense Accounts and Creating
Necessary Adjustments
An expense adjustment may occur when a company accrues expenses that
have not been paid. A typical example would be wages employees earned
but have not been paid. An accountant would record unpaid salaries as a
liability and an expense as the company has incurred an expense.

JOURNAL Page 86
Date Description P.R. Debit Credit
20–
1,200.0
Dec. 1 Supplies
0
Accounts Payable 1,200.00
To record purchase of paint supplies
Finding Errors and Creating Adjustments

Start the process by asking yourself these three questions when dealing
with errors:

1. What type of error is it?

2. How should this error be fixed?
3. How did this error affect the financial statements?
Finding Errors and Creating Adjustments (cont.)

Here are examples of common accounting errors to watch for:

● Transposition Error. Reversing or transposing digits (e.g. 3874 instead of 3784).

● Omission Error. A transaction isn’t recorded like a sale or expense is overlooked
(example: a cash sale of a TV wasn’t written down in the rush of a black Friday
sale).
● Entry Reversal. An entry is debated instead of credited or vice versa.
● Subsidiary Entries. A transaction is incorrectly entered, usually not caught until
reconciling the bank statement.
● Rounding Error. When a number is rounded up or down and can have a
cascading effect on subsequently.
● Error of Commission. An amount is entered as the correct account and amount,
but is actually incorrect. For example, an amount was added instead of subtracted
or charged on one invoice when it should have been applied to a different invoice.
Finding Errors and Creating Adjustments

Now that you understand what type of error it is, it’s time to classify it as a
deferral (also known as prepayment) or an accrual. Then ask, “Is it part of
accrued revenue, accrued expense, deferred (unearned) revenue, or
deferred (prepaid) expense?” Once those steps have been discovered, an
adjusted journal entry is created to fix it.
JOURNAL Page 86
Date Description P.R. Debit Credit
20–
Dec.
Cost of Goods Sold 600
31
Inventory 600
Adjustment for inventory shrinkage
Finding Errors and Creating Adjustments

Errors in the accrued and deferred (unearned or prepaid) revenues and

expenses affect the Balance Sheet and Income Statement in the following
manner:

Before Adjusting
Balance Sheet Income Statement
Adjusting Entry
Not Recorded Net
Assets Liabilities Equity Revenue Expenses
Income

Understate
Accrued Revenues Understated Understated Understated
d

Accrued Expenses Understated Overstated Understated Overstated

Understate
Unearned Revenues Overstated Overstated Understated
d

Prepaid Expenses Overstated Overstated Understated Overstated

Preparing an Adjusted Trial Balance
Learning Outcomes: Preparing an Adjusted Trial
Balance
4.3: Creating the adjusted trial balance
4.3.1: Posting adjusting entries to the ledgers and re-balancing the
accounts
4.3.2: Creating an adjusted trial balance using a worksheet
Posting Adjusting Entries to the Ledgers and Re-
Balancing the Accounts
• After preparing the journal entries, post them to the ledgers.
• Each account is analyzed and verified to start to create the adjusted trial
balance:
• Checking
• Accounts Receivable
• Supplies
• Prepaid Rent
• Accounts Payable
• Capital Contributions
• Owner Withdrawals
• Service Revenue
• Insurance Revenue
• Rent Expense
• Supplies Expense
• Contractor Expense
Using the Worksheet (Trial Balance)
NeatNiks
Trial Balance (unadjusted)
For the month ended October 31, 20XX
Reference No. Accounts Debits Credits

110 Checking 3,500.00

120 Accounts Receivable 5,650.00

125 Supplies 2,600.00

12,000.0
130 Prepaid Rent
0

210 Account Payable 1,600.00

220 Contractor Payable –

310 Nick Frank, Capital Contributions 20,000.00

330 Nick Frank, Withdrawals 4,000.00

410 Service Revenue 8,750.00

510 Insurance Revenue 1,500.00

520 Rent Expense –

530 Supplies Expense –

540 Contractor Expense 1,100.00

30,350.0
Totals 30,350.00
0
Using the Worksheet (Proposed Adjustment)
NeatNiks
Trial Balance
For the Month ended October 31, 20XX
Unadjusted Trial Balance Adjustments Adjusted Trial Balance
Reference
Accounts DR CR DR CR DR CR
No.
110 Checking 3,500.00 3,500.00
120 Accounts Receivable 5,650.00 5,650.00
125 Supplies 2,600.00 2,600.00
130 Prepaid Rent 12,000.00 12,000.00
210 Accounts Payable 1,600.00 1,600.00
220 Contractor Payable – –
310 Nick Frank, Capital Contributions 20,000.00 20,000.00
330 Nick Frank, Withdrawals 4,000.00 4,000.00
410 Service Revenue 8,750.00 8,750.00
510 Insurance Expense 1,500.00 1,500.00
520 Rent Expense – –
530 Supplies Expense – –
540 Contractor Expense 1,100.00 1,100.00
30,350 30,350 30,350 0,350
Using the Worksheet (Proposed Adjustment)
NeatNiks
Trial Balance
For the Month ended October 31, 20XX
Unadjusted Trial Adjusted Trial
Adjustments
Ref Balance Referenc Balance
Accounts
No. e Referenc
DR CR DR CR DR CR
e
110 Checking 3,500.00 3,500.00
120 Accounts Receivable 5,650.00 5,650.00
125 Supplies 2,600.00 AJE1 1,600.00 2,600.00
130 Prepaid Rent 12,000.00 AJE2 2,000.00 12,000.00
210 Accounts Payable 1,600.00 1,600.00
220 Contractor Payable – AJE3 1,200.00 –
Nick Frank, Capital 20,000.0
310 20,000.00
Contributions 0
330 Nick Frank, Withdrawals 4,000.00 4,000.00
410 Service Revenue 8,750.00 8,750.00
510 Insurance Expense 1,500.00 1,500.00
520 Rent Expense – AJE2 2,000.00 –
530 Supplies Expense – AJE1 1,600.00 –
540 Contractor Expense 1,100.00 AJE3 1,200.00 1,100.00
Creating An Adjusted Trial Balance Using a
Worksheet
Once we have made all the
adjustments to the ledger
accounts and we have run the
adjusted trial balance and feel
confident all assets, liabilities,
capital accounts, revenues, and
expenses are recorded and are
being reported according to GAAP
(or, if we are a small business, as
close to GAAP as we want to be),
then we are ready for the final
step: to create the financial
statements.
Practice Question 2

Kwan Chou has finished putting together adjusting entries and rebalanced
the accounts for the most recent accounting period. She now needs to put
together an Adjusted Trial Balance. Which of the following tools is best for
her to use to prepare for the Trial Balance?

A. Worksheet
B. Balance Sheet
C. Income Statement
D. Bank Statement
Preparing Financial Statements
Learning Outcomes: Preparing Financial
Statements
4.4: Use an adjusted trial balance to prepare financial statements
4.4.1: Prepare an income statement
4.4.2: Prepare a statement of owner's equity
4.4.3: Prepare a balance sheet
4.4.4: Identify the three main components of the statement of cash flows
Prepare an Income Statement

• The first statement to prepare from the Adjusted Trial Balance is the
Income Statement.
• The income statement, sometimes called a statement of earning, or a profit and
loss (P&L) shows the results of operations by reporting net income. Net income is
revenues less expenses (see the highlighted accounts on the adjusted trial
balance above).
• When we compile these reports, we don’t use debits and credits. Those are only
used when we are recording transactions. For these reports, we just use regular
numbers that ordinary people can easily grasp.
• The expenses are all listed and a single underline showing we are subtotaling
them, with that subtotal listed directly underneath the revenue - the bottom line.
Net Income is shown as the combination of the two numbers above it. The
external user knows the net income is revenue minus expenses, so we don’t have
to reiterate that on the statement.
Prepare a Statement of Owner’s Equity

The statement of owner’s equity builds off the income statement, starting
with revenues and expenses combined ($1,350 net income), adding capital,
and subtracting any withdrawals.
NeatNiks
Statement of Owner’s Equity
For the month ended October 31, 20XX
Nick Frank, Capital, October 1, 20XX $0
Owner contributions 20,000
Net income/(loss) for the month 1,350
21,350
Owner withdrawals (4,000)
Nick Frank, Capital, October 31, 20XX $17,350
 Neatniks
Balance Sheet
As of October 31, 20XX
Prepare a Balance Sheet Description Amount
Assets
Cash $3,500
The balance sheet shows the Accounts Receivable 5,650
accounting equation: A = L + E. Supplies 1,000
Prepaid Rent 10,000
Total Assets $20,150

Liabilities
Accounts Payable $1,600
Wages Payable 1,200

Total Liabilities $2,800

Owner’s Equity
17,350
Total Liabilities and Owner’s Equity $20,150
Identify the Three Main Components of the
Statement of Cash Flows
• There are three sections to the statement of cash flows:
• Cash from operations
• Cash from investing
• Cash from financing
• Two different ways to present the statement of cash flows: the direct
method and the indirect method. They are only different in the way they
present cash from operations.
• Direct method reports cash receipts and disbursements as if the income
statement had been prepared on a cash basis.
• Indirect method starts with accrual basis net income and reconciles it to cash
basis.
Closing the Books
Learning Outcomes: Closing the Books

4.5: Prepare and post closing entries

4.5.1: Identify permanent and temporary accounts
4.5.2: Prepare closing entries
4.5.3: Post closing entries and prepare the post-closing trial balance
4.5.4: Demonstrate reversing entries
Identify Permanent and Temporary Accounts

• Permanent accounts: balance sheet accounts including assets,

liabilities, and equity accounts (except for withdrawals). These account
balances roll over into the next period. The ending balance of this period
will be the beginning balance for next period.

• Temporary accounts: revenues, expenses, and withdrawals accounts.

These account balances do not roll over into the next period after
closing. The closing process reduces revenue, expense, and withdrawals
account balances (temporary accounts) to zero so they are ready to
accumulate data for the next accounting period.
Preparing Closing Entries

In accounting, we often refer to the process of closing as closing the books.

The four basic steps in the closing process are:
• Closing the Revenue Accounts: transferring the credit balances in the
revenue accounts to a clearing account called Income Summary.
• Closing the Expense Accounts: transferring the debit balances in the expense
accounts to a clearing account called Income Summary.
• Closing the Income Summary Account: transferring the balance of the
Income Summary account to the owner’s capital account.
• Closing the Withdrawal Account: transferring the debit balance of the owner
withdrawal account to the capital account.
Post Closing Entries and Prepare the Post-Closing
Trial Balance
• After we complete journal entries, we post to the ledger and run a post-
closing trial balance.
• Once we are satisfied everything is balanced, carry the balances forward
to the new blank pages of the next (now current) year’s ledger and are
now ready to start posting transactions.
• Remember, closing entries are only used in systems using actual bound
books made of paper. They are an important concept and officially
represent the end of the process.
Post Closing Entries (part I)
Post Closing Entries (part II)
Post Closing Entries (part III)
Post Closing Entries (part IV)
Demonstrate Reversing Entries

• After everything is closed and the old year is done, accountants

sometimes perform one more step that could be called the beginning of
the next accounting cycle as easily as it could be called the end of the
old.
• See if you can figure out what is wrong with these accounts. Once you
do, you’ll be able to see why we make reversing entries for some
accruals.
Practice Question 3

Which of the following choices is an example of a temporary account that is

closed at the end of the fiscal year?

A. Accounts Payable
B. Land
C. Inventory
D. Service Revenue
Class Activity: Financial Statement Discussion

• Refer to the four financial statements in the course for NeatNiks:

• Income Statement,
• Statement of Owner’s Equity,
• Balance Sheet,
• Statement of Cash Flows.
• Look through them carefully and find the connections and differences
between each other.
• Discussion these questions with a group of your classmates:
• Why is the Income Statements the first financial statement to prepare?
• What does each of the financial statements show or emphasize?
• How are each of the statements different from each other?
• Are some or all of the Statements necessary to have for a company? Why?
Quick Review

• Why is there a need for adjusting journal entries?

• What is the adjustment process?
• What is the difference between deferrals and accruals?
• How do you analyze revenue accounts and create the necessary
adjustments?
• How do you analyze expense accounts and create the necessary
adjustments?
• How do you find errors and create adjustments?
• How can you post adjusting entries to the ledgers and re-balance the
accounts?
• How can you create an adjusted trial balance using a worksheet?
More Quick Review

• How does an accountant prepare an income statement?

• How does an accountant prepare a statement of owner's equity?
• How does an accountant prepare a balance sheet?
• What are the three main components of the statement of cash
flows?
• Which accounts are permanent and which temporary?
• How do you prepare closing entries
• When do you post closing entries and prepare the post-closing trial
balance?
• What is the process for reversing entries?