Chapter 4: Review of the Accounting Cycle

Introduction

This chapter provides a comprehensive overview of the accounting cycle, a fundamental process in financial accounting. It covers the steps from transaction analysis to the preparation of financial statements and closing entries, ensuring that students understand how business transactions are systematically recorded and reported.

The Accounting Cycle

Definition and Overview

• Accounting Cycle: The sequence of steps used to record, classify, and summarize accounting information for a period, culminating in the preparation of financial statements.

• Both U.S. GAAP and IFRS follow this cycle, beginning with transaction analysis and ending with a post-closing trial balance.

Transaction Analysis and the Accounting Equation

Step 1: Analyze the Transaction

• A transaction is any economic event that changes an entity's assets, liabilities, or stockholders’ equity.

• The accounting equation is the foundation of double-entry accounting:

• Every transaction affects at least two accounts, maintaining the balance of the equation.

• The expanded accounting equation includes components of equity:

• A negative retained earnings balance is called a deficit.

Example: Transaction Analysis

• Issuing stock increases both cash (asset) and contributed capital (equity).

• Purchasing equipment for cash changes the composition of assets but not the total.

• Providing services for cash increases both cash and service revenue (equity).

• Paying expenses decreases cash and equity (through expense recognition).

Journalizing Transactions

Step 2: Journalize the Transactions

• Transactions are recorded in the general journal using debits (left) and credits (right).

• Each account has a normal balance side (debit or credit) where increases are recorded.

• Journal entries include the date, accounts affected, amounts, and a brief explanation.

Chart of Accounts

• A chart of accounts lists all account names and numbers, typically in balance sheet order: assets, liabilities, equity, revenues, and expenses.

Posting to the General Ledger

Step 3: Post to the General Ledger

• The general ledger contains all accounts and their balances.

• Posting transfers journal entry information to individual ledger accounts.

• A T-account is a simplified ledger account used for analysis, with debits on the left and credits on the right.

Preparation of the Unadjusted Trial Balance

Step 4: Prepare the Unadjusted Trial Balance

• A trial balance lists all accounts and their balances at a point in time, ensuring total debits equal total credits.

• It does not detect all errors (e.g., omitted entries, double postings, or incorrect accounts).

Adjusting Journal Entries

Step 5: Prepare Adjusting Journal Entries

• Adjusting journal entries (AJEs) ensure revenues and expenses are recognized in the correct period (accrual accounting).

• Each AJE affects one balance sheet account and one income statement account.

Deferrals

• Deferrals occur when cash is received or paid before revenue or expense recognition.

• Deferred expenses (prepaid expenses): Initially recorded as assets, then expensed as used.

• Deferred revenues (unearned revenues): Initially recorded as liabilities, then recognized as revenue when earned.

• Depreciation and amortization are systematic allocations of asset costs over their useful lives.

Accruals

• Accruals occur when revenue or expense is recognized before cash is received or paid.

• Accrued revenues: Revenue earned but not yet received in cash.

• Accrued expenses: Expenses incurred but not yet paid in cash.

Preparation of the Adjusted Trial Balance

Step 6: Prepare the Adjusted Trial Balance

• The adjusted trial balance lists all accounts after adjusting entries, ensuring debits equal credits and providing the basis for financial statement preparation.

Preparation of Financial Statements

Step 7: Prepare Financial Statements

• Financial statements are prepared in the following sequence:

  1. Income Statement

  2. Statement of Stockholders’ Equity

  3. Balance Sheet

• Net income from the income statement is used in the statement of stockholders’ equity and balance sheet.

Closing Temporary Accounts

Step 8: Close Temporary Accounts

• Temporary accounts (revenues, expenses, dividends) are closed to zero at period-end to prepare for the next period.

• Permanent accounts (assets, liabilities, equity) carry balances forward.

• Four closing entries are made: close revenues, close expenses, close income summary, and close dividends.

Preparation of the Post-Closing Trial Balance

Step 9: Prepare Post-Closing Trial Balance

• The post-closing trial balance lists only permanent accounts, confirming that temporary accounts have been closed and balances are ready for the next period.

Appendices: Alternative Treatments, Worksheets, and Reversing Entries

Alternative Treatment of Deferred Revenue and Expenses

• Some systems initially record prepaids as expenses or revenues collected in advance as revenue. Adjusting entries are required to correct these at period-end.

Using a Worksheet

• A worksheet is a tool for organizing the adjustment process and preparing financial statements. It includes columns for unadjusted balances, adjustments, adjusted balances, and statement allocations.

• Steps: Enter unadjusted balances, record adjustments, compute adjusted balances, allocate to statements, and calculate net income or loss.

Reversing Entries

• Reversing entries are optional entries made at the start of a new period to simplify the recording of subsequent transactions related to prior period accruals.

• Commonly used for accrued revenues and expenses.