Completing the Accounting Cycle

Introduction

The accounting cycle is a systematic process used by companies to produce financial statements for a specific period. It involves recording, summarizing, and reporting financial transactions to ensure accurate financial reporting and compliance with accounting standards.

Accounting Cycle Overview

• Definition: The accounting cycle refers to the sequence of steps followed to record and process all financial transactions of a business during an accounting period.

• Steps in the Accounting Cycle:

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

  2. Identify and analyze transactions as they occur.

  3. Record transactions in a journal.

  4. Post (copy) from the journal to the ledger.

  5. Prepare the unadjusted trial balance.

  6. Journalize and post adjusting entries.

  7. Prepare an adjusted trial balance.

  8. Prepare the financial statements.

  9. Journalize and post the closing entries.

  10. Prepare the post-closing trial balance.

• Permanent vs. Temporary Accounts:

  • Permanent accounts (assets, liabilities, owner's equity) carry balances over from period to period.

  • Temporary accounts (revenues, expenses, withdrawals) are reset to zero at the end of each period.

Accounting Worksheet

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

• Functions of the Worksheet:

  • Organizes accounting data

  • Records adjusting entries

  • Computes net income (or net loss)

  • Prepares financial statements

  • Identifies accounts needing adjustments

  • Helps close accounts

• Adjusting Entries: Adjusting entries may not be recorded in journals immediately; the worksheet helps prepare financial statements more quickly. Eventually, all adjusting entries must be journalized.

Closing Entries and the Closing Process

Closing entries are made at the end of the accounting period to reset temporary accounts and transfer their balances to permanent accounts.

• Purpose: Prepares accounts for the next period by setting revenue, expense, and withdrawal accounts to zero.

• Process:

  1. Transfer revenues and expenses to a temporary account called Income Summary.

  2. Transfer the Income Summary balance to the Capital account.

  3. Transfer the Withdrawal account balance to the Capital account.

• Interpretation:

  • A debit in Income Summary = net loss

  • A credit in Income Summary = net income

• Temporary (Nominal) Accounts: Revenues, expenses, withdrawals, and income summary accounts are temporary and closed at period end.

• Permanent Accounts: Assets, liabilities, and owner's equity are not closed and their balances carry over.

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

Accounting errors may occur and must be corrected to ensure accurate financial records.

• Before Posting: Correct the journal entry containing the error.

• After Posting: A correcting entry is required.

• Example: If $10,000 cash for furniture is incorrectly recorded as Office Supplies, two approaches can be used:

  1. Reverse the original entry and rewrite the correct one (preferred for audit trail clarity).

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

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.

• 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 classified as current.

  • 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 classified as current.

  • Examples: Long-term notes payable (due after one year).

Classified Balance Sheet

A classified balance sheet lists assets and liabilities in order of their relative liquidity and uses subtotals to classify accounts as either current or long-term. The format may be either account form (side-by-side) or report form (stacked), but the accounts and balances remain unchanged.

Accounting Ratios

Financial ratios are used to assess a company's financial position and performance. Two commonly used ratios are the current ratio and the debt ratio.

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

  • Formula:

  • A higher ratio indicates better liquidity; a ratio in the range of 1.5 to 2 is generally considered healthy.

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

  • Formula:

  • A lower ratio is safer; a debt ratio below 0.60 (60%) is preferred. Above 80% is considered high risk.

• Interpreting Ratios: No single ratio gives a complete picture; experienced decision makers examine multiple ratios over several years to spot 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 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, not for amortization or prepayments.

• Purpose: To reverse the effect of certain adjusting entries, making subsequent transaction recording easier.

• Method: Switch the debit and credit of the previous adjusting entry in the subsequent period.

• Example:

  • 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).

Using reversing entries ensures that expenses are recorded in the correct period and simplifies the recording of subsequent payments.