Completing the Accounting Cycle: Study Notes for Financial Accounting

Completing the Accounting Cycle

Introduction

The accounting cycle is a systematic process used by companies to produce financial statements for a specific period. This cycle ensures that all financial transactions are accurately recorded, summarized, and reported, providing a clear picture of a business's financial position.

Accounting Cycle Overview

The accounting cycle consists of several steps that begin with the opening of ledger accounts and end with the preparation of financial statements and closing of temporary accounts. The process is repeated for each accounting period.

• Step 1: Start with the balances in the ledger at the beginning of the period.

• Step 2: Identify and analyze transactions as they occur.

• Step 3: Record transactions in a journal.

• Step 4: Post (copy) from journal to ledger accounts.

• Step 5: Prepare the unadjusted trial balance.

• Step 6: Journalize and post adjusting entries.

• Step 7: Prepare an adjusted trial balance.

• Step 8: Prepare the financial statements.

• Step 9: Journalize and post the closing entries.

• Step 10: Prepare the post-closing trial balance.

Additional info: The worksheet is an optional tool used to organize data before preparing financial statements.

Accounting Worksheet

An accounting worksheet is a multi-column document used to summarize accounting data for the preparation of financial statements. While students may not be required to complete one in tests or homework, understanding its purpose is important.

• Helps organize accounting data.

• Assists in recording adjusting entries.

• Facilitates computation of net income or net loss.

• Prepares financial statements efficiently.

• Identifies accounts needing adjustments.

• Helps close accounts at period end.

Adjusting entries identified in the worksheet must eventually be journalized.

Closing the Accounts

At the end of the accounting period, closing entries are made to reset the balances of revenue, expense, and withdrawal accounts to zero, preparing them for the next period. This process ensures that each period's activities are measured separately.

• Closing entries transfer revenues and expenses to a temporary account called Income Summary.

• The balance in Income Summary is then transferred to the Capital account.

• A debit in Income Summary indicates a net loss; a credit indicates net income.

• Withdrawals are closed directly to the Capital account.

• After closing, revenue, expense, withdrawal, and income summary accounts have zero balances.

• These are called temporary (nominal) accounts.

• Permanent accounts (assets, liabilities, owner's equity) are not closed and their balances carry over to the next period.

Post-Closing Trial Balance

The accounting cycle ends with the post-closing trial balance, which serves as a final check on the accuracy of journalizing and posting adjusting and closing entries.

• Contains only the balances of permanent (balance sheet) accounts: assets, liabilities, and owner's equity.

• All temporary accounts, including withdrawals, should have zero balances.

Correcting Entries

Errors in journal entries can occur and must be corrected to ensure accurate financial reporting.

• If detected before posting, correct the original journal entry.

• If detected after posting, a correcting entry is required.

Example: Correcting an Entry

If $10,000 cash paid for furniture is incorrectly recorded as Office Supplies:

• Approach 1: Reverse the original entry and record the correct transaction.

• Approach 2: Make a one-step correcting entry to adjust only the affected accounts.

Additional info: The first approach is preferred for audit trails and clarity.

Classifying Assets and Liabilities

Assets and liabilities are classified based on their relative liquidity, which refers to how quickly an item can be converted to cash or how soon a liability must be paid.

• Balance sheet accounts are listed in order of liquidity or intended disposition.

• Classified balance sheets use subtotals to distinguish between current and long-term items.

• An asset or liability can have both current and long-term portions.

Current Assets

• Expected to be converted to cash, sold, or consumed within 12 months (or the operating cycle, if longer).

• Examples: Cash, Accounts Receivable, Notes Receivable (due within a year), Supplies, Prepaid Expenses, Inventory.

Long-Term Assets

• Not expected to be converted to cash within a year.

• Examples: Property, Plant, and Equipment (land, buildings, furniture), Goodwill, Intangibles, Long-term Investments.

Current Liabilities

• Debts due within one year or the operating cycle.

• Examples: Accounts Payable, Notes Payable (due within a year), Salaries Payable, Taxes Payable, Interest Payable, Unearned Revenue.

Long-Term Liabilities

• Debts not due within one year.

• Examples: Long-term Notes Payable (due after one year).

Classified Balance Sheet Formats

There are two main formats for presenting a classified balance sheet: Account Form and Report Form.

• Account Form: Assets are listed on the left, liabilities and owner's equity on the right.

• Report Form: Assets are listed at the top, followed by liabilities and owner's equity below.

• The accounts and balances remain unchanged; only the layout differs.

Accounting Ratios

Financial ratios are used by decision makers to assess a company's financial position and performance. Ratios allow for comparison against benchmarks and industry standards.

• Current Ratio: Measures the ability to pay current liabilities with current assets.

• Debt Ratio: Indicates the proportion of assets financed with debt.

Current Ratio Formula

The current ratio is calculated as:

$\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$

• A higher ratio indicates better liquidity; generally, a ratio above 1.0 is considered healthy.

Debt Ratio Formula

The debt ratio is calculated as:

$\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$

• A lower ratio is safer; a debt ratio below 0.60 (60%) is preferred.

• A debt ratio above 0.80 (80%) is considered high risk.

Interpreting Ratios

• Ratios are useful but should not be relied upon in isolation.

• Experienced users examine multiple ratios over several years to identify trends.

International Financial Reporting Standards (IFRS)

IFRS affects the accounting cycle and financial reporting by providing globally accepted standards for preparing financial statements. Companies must ensure their accounting practices align with IFRS requirements.

Reversing Entries (Appendix)

Reversing entries are optional journal entries made at the beginning of a new period to simplify accounting after adjusting and closing entries have been made. They are typically used with accrual-type adjustments.

• Reversing entries are not used for amortization or prepayment adjustments.

• They switch the debit and credit of a previous adjusting entry in the subsequent period.

Example: Reversing Entry for Accrued Salaries

• On July 31, accrue $3,000 in salaries (debit Salaries Expense, credit Salaries Payable).

• On August 1, reverse the accrual (debit Salaries Payable, credit Salaries Expense).

• On August 2, pay the total payroll of $5,000 (debit Salaries Expense, credit Cash).

• This ensures proper allocation of expenses between periods.

Additional info: Reversing entries simplify subsequent entries and maintain accurate expense recognition.