Review the available materials for the chapters covered this week, including the lecture, reading, publisher materials, demonstration problems and exercises at the end of the chapters. After reviewing these materials and attempting the assignment for the week, what challenges did you face? Do you have any questions on the material? Participate in follow up discussion by helping your classmates and sharing your tips for understanding materials, when possible.
The Adjusting and Closing Process
output of the accounting process is the financial statements. The
transactions that are entered into the accounting system are summarized
through the process of posting to the general ledger. The general
ledger accounts are then adjusted prior to the preparation of financial
statements. The adjusting process and the three basic financial
statements−the income statement, balance sheet, and statement of owners' equity−are examined in this module.
The Accrual Basis of Accounting
are two main methods of accounting: the cash basis of accounting and
the accrual basis of accounting. Under the cash basis of accounting,
revenue is recognized when cash is received, and expenses are recognized
when cash is paid. However, Generally Accepted Accounting Principles
(GAAP) requires the use of the accrual basis of accounting for almost
all companies. In accrual basis accounting, revenues are recognized when
earned, and expenses are recognized when incurred, regardless of when
cash is received or paid. In other words, "accrual basis accounting
means that transactions that change a company's financial statements are
recorded in the periods in which the events occur" (Kimmel, Weygandt,
& Kieso, 2009, p. 164).
basis of accounting requires the application of the revenue recognition
principle and the matching principle. The revenue recognition principle
dictates the following:
1.Revenues are recognized when the company performs services or delivery of goods has occurred.
2.There is persuasive evidence of an arrangement for customer payment.
3.The price is fixed or determinable.
4.Collection is reasonably assured (Libby, Libby, and Short, 2004).
matching principle requires that expenses be recognized when they are
incurred in generating revenue; therefore, expenses are matched
against the revenues that they help to generate. Because of the nature
of accrual basis accounting, not all revenues and expenses that should
be recorded in a given period are recorded as part of the normal
accounting process, typically because cash has not changed hands. As
such, adjustments are necessary to bring the books up to an accrual
basis of accounting.
The Adjusting Process
accounting cycle includes preparing journal entries, posting the
entries to the general ledger, preparing a trial balance, adjusting the
accounts to bring them in accordance with an accrual basis of
accounting, preparing an adjusted trial balance, preparing financial
statements, and closing the books.
entries are necessary whenever financial statements are going to be
prepared in order to bring the asset, liability, revenue, and expense
accounts into accordance with the accrual basis of accounting. Adjusting
entries are made for prepayments and accruals. Prepayments exist
whenever cash exchanges hands prior to goods or services being
delivered, rendered, or used. Prepaid expenses are considered assets
until used and unearned revenues are liabilities until the goods are
delivered or the services rendered. Accrual entries are the original
recording of a transaction, and accruals are necessary when cash has not
yet been exchanged but revenues have been earned or expenses incurred.
adjusting entries affect both the balance sheet and the income
statement, but adjusting entries never affect cash. The accountant must
identify all of the adjustments that are necessary because the adjusting
journal entries are not naturally prepared through the normal course of
business operations. To identify adjusting journal entries required for
prepayments, the accountant must review the unadjusted trial balance
and search for prepaid assets, including supplies and long-term
depreciable assets, and unearned revenues that must be adjusted. The
accountant must also find any revenues and expenses that need to be
accrued through reviewing prior period accruals and making inquiries of
After the adjusting entries are
identified, they must be posted to the ledger and a post-closing trial
balance must be prepared. The following summarizes the types of
adjustments that must be identified and journalized:
Preparation of the Financial Statements
adjusted trial balance becomes the basis for the preparation of
financial statements. Three of the financial statements−the income
statement, statement of retained earnings, and balance sheet−are
prepared, in that order, directly from the adjusted trial balance. To
prepare the fourth financial statement required by GAAP, the statement
of cash flows, it is necessary to use the other three statements as well
as supplemental information.
income statement summarizes the revenue and expense items earned or
incurred for a period of time. The difference between revenues and
expenses is called the net income or the net loss. Net income exists
when revenues exceed expenses, and net loss exists when expenses exceed
revenues. The net income calculated in the income statement is used in
preparing the statement of retained earnings.
Statement of Owners' Equity
equity is equal to assets minus liabilities; therefore, it is the
residual amount left for the owners of the company after a third party's
claims against assets are satisfied. Owners' equity can change based
upon activities of the owners (additional capital investments or
distributions of profits) or the activities of the company's operations
(resulting in net income or net loss). The statement of owners' equity
shows how the beginning balance became the ending balance in owners'
equity. This is done by starting with the beginning balance, adding net
income or subtracting net loss, and subtracting distributions paid
during the period to get the ending balance in owners' equity. The
ending balance in owners' equity is then used to prepare the balance
balance sheet, unlike the income statement and the statement of
retained earnings, is not for a period of time, but rather for a point
in time. The balance sheet presented with a complete set of financial
statements is as of the final date in the period covered by the income
statement. The balance sheet proves that the accounting equation is in
balance by showing that the total assets are equal to the total
liabilities plus owners' equity. In order to make the balance sheet
"balance," the balances in the asset and liability accounts are taken
off of the adjusted trial balance, but the owners' equity balance is
taken from the ending balance in the statement of retained earnings.
Statement of Cash Flows
final financial statement prepared is the statement of cash flows. The
statement of cash flows shows how the beginning cash balance became the
ending cash balance by summarizing the business' cash inflows and
outflows into its operating activities, investing activities, and
financing activities. The statement of cash flows will be examined in
further detail in upcoming modules.
The Closing Process
the financial statements are prepared, the books must be prepared for
the next period by closing all of the temporary accounts. All accounts
are either real (permanent) or nominal (temporary). Real accounts carry
their balances forward from period to period, while nominal accounts are
the accounts for which accountants measure only the activity of a
particular period and then start re-measuring for future periods.
expenses, gains, and losses are all temporary accounts that are
measured for a one-year period and then are closed to a zero balance at
the end of the year to allow for the new accumulation of income and
expense items in the following period.
entries transfer net income or loss and dividends to the retained
earnings account so that the balance in retained earnings, post-closing,
matches the retained earnings balance on the statement of retained
earnings for the period (Kimmel et al., 2009). To close these accounts,
every revenue and gain account is debited for its exact balance, every
expense and loss account is credited for its exact balance, and the
difference (equal to net income) is credited to the retained earnings
If a company has a net loss for the
period, the closing entry will require a debit or decrease to retained
earnings to balance the closing entry. Dividends or other distributions
to owners are closed to retained earnings by debiting retained earnings
and crediting dividends.
After the closing
entries are journalized and posted to the general ledger, a post-closing
trial balance can be prepared. The post-closing trial balance will only
have balances for the real accounts, as all nominal accounts will have
been closed. The only real account that should have its balance change
from the adjusted trial balance amount is retained earnings.
accounting cycle has now been reviewed in full; this includes
journalizing transactions, posting to the general ledger, preparing the
trial balance, adjusting the books and posting the adjusting entries,
preparing financial statements, and finally closing the books. In the
upcoming modules, the accounts will be examined in detail to understand
the principles that are applied to each type of account on the balance
Kimmel, P., Weygandt, J., & Kieso, D. (2009). Accounting: Tools for business decision making (3rd ed.). Hoboken, NJ: John Wiley and Sons, Inc.
Libby, R., Libby, P., & Short, D. (2004). Financial accounting
(4th ed.). Boston: McGraw-Hill/Irwin
Horngren’s Accounting, The Financial Chapters
Read chapters 3 and 4.http://gcumedia.com/digital-resources/pearson/2013/horngrens-accounting-the-financial-chapters-with-myaccountinglab_ebook_10e.phphe