Measuring Business Income and Completing the Accounting Cycle: Study Notes

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Measuring Business Income and Completing the Accounting Cycle

Introduction

This study guide covers essential topics in Financial Accounting, focusing on measuring business income and completing the accounting cycle. It includes explanations of adjusting and closing journal entries, preparation of trial balances, and the analysis of typical transactions encountered in service and merchandising businesses.

Adjusting Journal Entries

Purpose and Importance

Adjusting journal entries are made at the end of an accounting period to update account balances before preparing financial statements. These adjustments ensure that revenues and expenses are recognized in the correct period, in accordance with the accrual basis of accounting.

Accruals: Recognize revenues earned and expenses incurred that have not yet been recorded.
Deferrals: Adjust for cash received or paid in advance, such as prepaid expenses or unearned revenues.
Depreciation: Allocate the cost of long-lived assets over their useful lives.

Example: If a company has earned interest revenue but has not yet received payment, an adjusting entry is required to recognize the revenue in the current period.

Formula for Depreciation (Straight-Line):

Closing Journal Entries

Purpose and Process

Closing entries are made at the end of the accounting period to transfer the balances of temporary accounts (revenues, expenses, and withdrawals) to permanent accounts (owner's equity or retained earnings). This process resets the temporary accounts to zero for the next period.

Step 1: Close all revenue accounts to Income Summary.
Step 2: Close all expense accounts to Income Summary.
Step 3: Close Income Summary to Owner's Capital (or Retained Earnings).
Step 4: Close Withdrawals/Dividends to Owner's Capital (or Retained Earnings).

Example: If total revenues are $100,000 and total expenses are $80,000, the net income of $20,000 is transferred to Owner's Capital.

Trial Balances

Types and Preparation

A trial balance is a list of all ledger accounts and their balances at a particular date. It is used to verify that total debits equal total credits. There are three main types:

Unadjusted Trial Balance: Prepared before adjusting entries.
Adjusted Trial Balance: Prepared after adjusting entries.
Post-Closing Trial Balance: Prepared after closing entries, showing only permanent accounts.

Example: After all closing entries, only asset, liability, and equity accounts appear in the post-closing trial balance.

Transaction Analysis

Identifying and Recording Transactions

Transaction analysis involves determining the financial impact of business events and recording them in the appropriate accounts. Each transaction affects at least two accounts and must maintain the accounting equation:

Journalizing: Recording transactions in the journal as debits and credits.
Posting: Transferring journal entries to ledger accounts.

Example: Purchasing equipment for cash decreases cash and increases equipment (both asset accounts).

Sample Account Balances and Adjustments

Bell Theatre Example

At year-end, Bell Theatre has various account balances that require closing entries and preparation of a post-closing trial balance. Key accounts include cash, supplies, equipment, revenues, and expenses.

Account	Balance
Cash	$6,000
Concession supplies	$4,000
Theatre equipment	$50,000
Accumulated depreciation	$12,000
Accounts payable	$2,000
T. Bell, capital	$20,000
Admission ticket revenues	$120,000
Popcorn revenues	$18,000
Concession supplies expense	$12,000
Depreciation expense	$12,000
Rent expense	$15,000
Utilities expense	$13,000

Required Steps:

Prepare closing journal entries for all revenue and expense accounts.
Prepare a post-closing trial balance showing only permanent accounts.

Comprehensive Accounting Cycle Example

Betty's Cleaning Service

This example demonstrates the full accounting cycle, including journalizing transactions, posting to ledger accounts, preparing trial balances, making adjustments, and preparing financial statements.

Journalizing July Transactions: Record all business events for the month.
Trial Balance: List all account balances as of July 31.
Adjusting Entries: Record depreciation, insurance expense, accrued salaries, and interest expense.
Financial Statements: Prepare income statement, statement of owner's equity, and balance sheet.
Closing Entries: Close temporary accounts to owner's equity.
Post-Closing Trial Balance: List only permanent accounts.

Example of Adjusting Entry for Depreciation:

per year

Example of Accrued Salaries: If employees have earned $800 but have not been paid, record Salaries Expense and Salaries Payable for $800.

Summary Table: Types of Journal Entries

Type	Purpose	Timing
Regular Journal Entry	Record daily transactions	Throughout period
Adjusting Entry	Update accounts for accruals/deferrals	End of period
Closing Entry	Reset temporary accounts	End of period
Post-Closing Entry	Verify permanent account balances	After closing entries

Key Terms and Definitions

Accrual Accounting: Recognizes revenues and expenses when they are earned or incurred, not when cash is exchanged.
Adjusting Entry: Journal entry made at the end of an accounting period to update account balances.
Closing Entry: Journal entry that transfers balances from temporary accounts to permanent accounts.
Trial Balance: A list of all accounts and their balances at a specific date.
Depreciation: Allocation of the cost of a long-lived asset over its useful life.
Owner's Equity: The owner's claim on the assets of the business after liabilities are paid.

Conclusion

Understanding the accounting cycle is fundamental to preparing accurate financial statements. Mastery of adjusting and closing entries, trial balances, and transaction analysis ensures compliance with accounting principles and provides meaningful financial information for decision-making.