Intermediate Accounting - Ch. 4 PP (Review of the Accounting Cycle)

Adjustment entries for accrued expenses:

debit (increase) expense account and credit (increase) liability account

Accounting Cycle

describes the process by which a company records business transactions and ultimately aggregates and summarizes them in the financial statements.

Earned Capital

net income generated and retained by the firm.

Step 1: Analyze the Transaction

- A transaction is an economic event that involves a change in an asset, a liability, or a stockholders' equity account that companies record in their accounting records. - The accounting equation illustrates the relationship among assets, liabilities, and stockholders' equity as follows: ---> Assets = Liabilities + Stockholders' Equity - The accounting equation will always balance - All transactions affect at least two accounts ---> Ex) if an asset increases, then there must either be a decrease in another asset, an increase in liabilities, or an increase in stockholders' equity.

Step 5: Prepare Adjusting Journal Entries

- Adjusting journal entries are entries made to ensure that all revenues are recognized in the period earned and all expenses are recognized in the period incurred. ---> Adjusting journal entries involve accounting for both deferrals and accruals. - Deferrals occur when a company receives or pays cash before recognizing the revenue or expense in the financial statements. - Accruals occur when the economic event that gives rise to revenue or expenses occurs before the cash is received or paid.

Step 2: Journalize the Transactions

- After analyzing the transaction, the second step in the accounting cycle is to journalize the transaction by formally recording the transaction in the accounting system. - A company records each transaction in specific accounts. - Companies use debits and credits to journalize transactions. - The terms debit and credit simply mean the left and the right side of an account, respectively; they do not imply increases or decreases. - All transactions will result in debits equal to credits. - The normal balance refers to the expected balance in an account, and it is the side that increases the value of the account. ---> Note: The balance of retained earnings can be a debit when expenses, losses, and dividends exceed revenues and gains over time. A debit balance in retained earnings is called a deficit.

Step 4: Prepare the Unadjusted Trial Balance

- After completing the posting process, the company prepares the unadjusted trial balance, an initial listing of all accounts and their debt or credit balances. - A trial balance will not reveal the following errors: ---> A transaction that is not journalized. ---> A correct journal entry that is not posted. ---> An entry that is posted twice. ---> The debiting or crediting of incorrect accounts. ---> Debiting and crediting incorrect dollar amounts.

Double Entry Bookkeeping

- For every transaction, recording the dual effect by making the appropriate debit entry and credit entry. - Why bother with double entry accounting? ---> Provides "cause" and "effect." ---> Not only do we know what has happened, but why it has happened. -------->The firm may have sold equipment and received cash. -------->Alternatively, the firm may have provided services in exchange for cash. -------->In both cases, the firm has more cash. Double entry bookkeeping explains how the cash came about.

Step 3: Post to the General Ledger

- The next step in the accounting cycle is to post the journalized transactions to the general ledger. - The general ledger contains all accounts maintained by the company, with each account reflecting its increases, decreases, and balance. - Posting is the process of transferring information contained in journal entries to the individual ledger accounts.

Step 8: Close Temporary Accounts

- The next step in the accounting cycle requires closing all temporary accounts, which are all income statement accounts and dividends that must be reduced to a zero balance in order to report net income (or net loss) and dividends for the next accounting period. - Closing is the process of bringing all temporary accounts to a zero balance. - Permanent accounts are accounts with cumulative balances carried forward period after period. - Permanent accounts are not closed at the end of the period.

Trial Balance

- a listing of the accounts and their ending debit or credit balances at a point in time. - Provides a check on the recording process by ensuring the equality of debits and credits. ---> However, it does not prove the accuracy of the recording process.a proof of the equality of debits and credits in a general ledger

Accounting Cycle allows users to answer:

-How much and what kind of debt is outstanding? -Were sales higher this period than last? -What assets does the firm have? -What were cash inflows and outflows? -Did firm make a profit last period? -Can the firm safely increase dividends to stockholders? -Is the rate of return on net assets increasing?

9 Steps to the Accounting Cycle

1. Analyze the transaction 2. Journalize the transaction 3. Post to the General Ledger 4. Prepare the Unadjusted Trial Balance 5. Prepare adjusting journal entries 6. Prepare the Adjusted Trial Balance 7. Prepare Financial Statements 8. Close Temporary Accounts 9. Prepare Post-Closing Trial Balance

Sequence of Preparation of Financial Statements

1. Statement of Net Income 2. Statement of Stockholders' Equity 3. Balance Sheet 4. Statement of Cash Flows

Adjusting Entries for Accruals

If a company does not make adjustments for accruals, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated.

Adjusting Entries for Deferrals

If a company does not make adjustments for deferrals, the asset and liability are overstated, and the related expense and revenue are understated.

Accrued Revenues

Occur when a company has earned revenues but has not yet received cash. - Examples: interest revenue, commissions, fees - If the company does not adjust accrued revenue, then assets and revenues are both understated. - The adjusting journal entry debits the asset account and credits the revenue account. - Once the cash is received, the company debits cash and credits the asset (receivable) account.

T-Account

a simplified version of general ledger accounts that have three main parts: ---> 1. The account title, ---> 2. A left (debit) side, and ---> 3. A right (credit) side.

Which of the following is a permanent account?

accounts receivable & goodwill

Account

an individual record of increases and decreases in specific asset, liability, and stockholder equity items.

Adjusting Entries for unearned revenues

debit (decrease) a liability account and credit (increase) a revenue account

Adjustment entries for accrued revenues:

debit (increase) an asset account and credit (increase) revenue account

Adjustment entries for prepaid expenses:

debit (increase) an expense account and credit (decrease) an asset account

Debit always means the...

left side of an account

Normal Balance

the side that increases the account.

Deferrals - Deferred Expense

- A deferred expense (prepaid expense) occurs when a company makes a cash payment before incurring an expense under accrual basis accounting. ---> Ex) prepaid rent, prepaid insurance, supplies - Companies record deferred expenses as assets until they are used or consumed in operations. - The adjusting journal entry (for incurring the expense) results in a debit to an expense account and a credit to an asset account. - If the company does not adjust the prepaid expense, it will overstate assets and understate expenses.

Deferrals - Deferred Revenue

- A deferred revenue (unearned revenues / advance collections) occurs when a company receives cash before earning revenue and recognizes it on the financial statements under accrual basis accounting. ---> Examples: advance collections of insurance, rent, and subscriptions. - Companies record unearned revenues as liabilities until they are earned. - The adjusting journal entry (for revenue earned) results in a debit to a liability account and a credit to a revenue account. - If the company does not adjust unearned revenue, it overstates liabilities and understates revenues.

Step 9: Prepare Post-Closing Trial Balance

- After journalizing and posting all closing entries, the company prepares a post-closing trial balance. - The post-closing trial balance contains only permanent balance sheet accounts because all temporary accounts were closed out and have zero balances.

Step 6: Prepare the Adjusted Trial Balance

- Companies prepare adjusted trial balances after journalizing and posting all adjusting journal entries. - The adjusted trial balance is the listing of all accounts and their ending debit or credit balances after making the adjusting journal entries. - The adjusted trial balance ensures the equality of debits and credits after adjusting journal entries are made but cannot be used to prove the accuracy of the financial information included in the accounts. - The accounts included in the adjusted trial balance contain all data needed to prepare the financial statements.

Four closing entries are required to close the temporary accounts:

1. Revenue accounts 2. Expense accounts 3. Income summary account 4. Dividends account

To close income summary account:

Debit income summary and credit retained earnings for the amount of net income; conversely, credit income summary and debit retained earnings in the event of a net loss.

To close expense accounts:

Debit income summary for total expenses and losses and credit each expense and loss account for its balance.

The Expanded Accounting Equation

includes the components of stockholders' equity: ---> Assets = Liabilities + Contributed Capital + (Beginning Retained Earnings + Revenues and Gains - Expenses and Losses - Dividends Declared) + Accumulated Other Comprehensive Income - There are two components of owners' equity: ---> Contributed capital ---> Earned capital

Step 7: Prepare Financial Statements

After completing the adjusted trial balance, the company can prepare financial statements.

Stockholders' Equity =

Common Stock + Retained Earnings - Dividends + Revenues - Expenses

Revenue Normal Balance =

Credit

Stockholders' Equity Normal Balance =

Credit

Expenses Normal Balance =

Debit

To close revenue accounts:

Debit all revenue and gain accounts and credit income summary for the total of the accounts debited.

To close dividends account:

Debit retained earnings and credit the dividends account for the year.

Accrued Expenses

Occur when a company has incurred expenses but has not paid cash (or recorded liability). - Examples: interest, rent, taxes, salaries - In these cases, there is an unrecorded liability (a payable) and an unrecognized expense. - The company understates both liabilities and expenses until it makes the adjusting journal entry. - The adjusting journal entry debits the expense account and credits the liability account. - Once cash is paid, the company debits the liability (payable) and credits cash.

Which of the following is a temporary account?

Salary Expense

Contributed Capital

initial investment from stockholders.

The double-entry accounting system means:

the dual effect of each transaction is recorded with a debit and a credit.