Completing the Accounting Cycle
At this point it is a good idea to differentiate between accrual and cash accounting.
Record Revenue as earned (regardless of when cash is paid)
Record Expense as incurred (regardless of when expense is paid)
Record Revenue as cash is received (regardless when the sale is made)
Record Expense when paid (regardless when the cost is incurred)
Throughout this course we will be using accrual accounting as it usually does a better job of measuring performance. However, some small companies may properly use the cash method of accounting or a hybrid method, accounting for revenue using the cash method and recording expenses using accrual accounting.
In Chapter 2 we introduced some generally accepted accounting principles and concepts. Let’s now introduce three new concepts and principles.
The time period concept states that even though a business may continue indefinitely, operating results need to be reported at regular intervals. These regular intervals usually are monthly, quarterly, and annually. An accounting time period that is one year in length is called a fiscal year. Most companies end their fiscal year on December 31. However, some companies, because the nature of their business, end their year on some other date.
The revenue recognition principle states that revenue should be recognized in the period in which revenue is earned. Typically, this is when a product is sold or a service performed. As a reminder, we will be using accrual accounting in this course meaning that revenue is recorded when earned regardless of when the cash is received.
The matching principle states that expenses of a period should be matched against the revenue earned during the same period.
When using accrual accounting and in order for revenues to be recorded in the period in which they are earned and for expenses to be recognized in the period in which they are incurred, adjusting entries need to be made. The need for adjusting entries can be seen by examining the trial balance of Svendsen Service Company on Page 116. Because business transactions have taken place during the month, some of the balances on the trial balance are incorrect. For example, if some of the supplies have been used during the month it is not accurate to continue showing Supplies with a balance of $5,500.
The authors separate adjustments into four categories as follows:
receivables represents revenue earned but not yet recorded in the books and
records. The adjusting entry takes the following form:
Please study the discussion of unrecorded receivables on Pages 145
Unrecorded liabilities represent expenses that a business has incurred but not yet paid. Examples are Salary Expense at the end of the period, Interest Expense at the end of the period, etc. The adjusting entry takes the following form.
Carefully study the discussion of unrecorded liabilities on Pages 145-6.
Adjustment – Prepaid Expenses
Prepaid expenses are expenses paid in cash and recorded in assets before they are used up. Examples of prepaid expenses are supplies, prepaid rent, and prepaid insurance. The adjusting entry takes the following form:
Prepaid expenses are discussed on Pages 147-8.
Though not discussed in the adjustments section of this textbook, another type of prepaid expense is the purchase of plant assets such as building, equipment, etc. These assets provide service for a number of years and they are recorded at cost when purchased. In compliance with the matching principle the cost of these long-lived assets much be spread over their useful lives. The allocation of a long-lived asset to expense is called depreciation expense.
As an example of this type of expense, let's consider the ceiling projector in a classroom. Let's assume that this projector costs $5,000 and has a useful life of 5 years at which time it will have zero salvage value. Annual depreciation expense would be $5,000/5 or $1,000 per year. The adjusting entry takes the following form:
Note that the credit is to Accumulated Depreciation not to the asset itself. The Accumulated Depreciation account accumulates all depreciation charged off to date and its normal balance is a credit. Accumulated Depreciation is a contra asset account meaning it has a matching pair, Equipment, for example, and it has the opposite balance of its matching pair.
On the balance sheet, the original cost of the long lived asset will be reflected. However, the book value will also be shown. For example, at the end of year one the balance sheet should reflect the historical cost and book value of the projector as follows:
Less: Accumulated Depreciation
Book value $4,000
At the end of year two the book value would be $3,000 and so on.
Category 4 Adjustment – Unearned Revenues
Unearned revenue arises when a business receives cash before earning the revenue. For accounting purposes, it is categorized as a liability since the firm is liable for future performance and has received cash in advance of the work being accomplished. The adjusting entry takes the following form:
The purpose of making adjusting entries for unearned revenues is to show the reduction in the liability and to record the appropriate revenue. Again, carefully study the discussion of unearned revenues on Page 149-150.
Note that each adjusting entry affects one income statement account and one balance sheet account and that Cash is never adjusted.
After the adjusting entries have been journalized and posted, an adjusted trial balance (Page 152) is prepared by listing the ending balances of all the accounts. From the adjusted trial balance it is a simple matter to prepare correct financials for General Motors as displayed on Pages 152-4. In this process note that net income is carried down to the Statement of Retained Earnings (Page 154) and that ending Retained Earnings is carried down to the owners’ equity section of the balance sheet.
At the end of the accounting period, the books and records must be closed and made ready for the next period. As part of the closing process all temporary (nominal) accounts must be closed out so that their balances are zero as the company begins a new accounting period. Temporary accounts which must be closed out include all revenue accounts, all expense accounts, and dividends. These accounts must be closed out at year-end and set back to a zero balance for the start of the new accounting period.
Permanent (real) accounts including assets, liabilities, and certain stockholder equity accounts are not closed out. For example, if the company has a balance of $50,000 in the Cash Account at midnight on December 31 it will have this same balance on January 1 and this account should not be closed out. However, temporary accounts must be closed out so that the accountant can begin accumulating revenues and expenses for the new period.
The closing entries transfer the revenue, expense, and dividends balances to Retained Earnings. The three steps involved are as follows:
1. Debit each revenue account for the amount of its credit balance. Credit Retained Earnings.
2. Credit each expense account for the
amount of its debit balance. Debit Retained Earnings for the sum of the
3. Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings
Note that after the closing entries are posted to the ledger, only permanent (balance sheet) accounts have balances. At this time, a post closing trial balance (Exhibit 10, Page 159) should be prepared to be sure that total debits equal total credits at the end of the period.
Please skip the section entitled Adjusting Entries: Original Entries to Expense or Revenue on Pages 161-3.