The Accounting Cycle and Accrual Accounting Concepts
Accounting Information System | Journal, Ledger Accounts, and Trial Balance | Cash-Basis Versus Accrual-Basis Accounting | Accrual Accounting Concepts | Adjusting Entries, Adjusted Trial Balance, and Closing | Self-Assessment
After learning about the income statement and the balance sheet in Chapters 1 and 2, we are now being introduced to the accounting cycle and certain underlying accounting concepts that influence the contents of those two financial statements.
Accounting Information System Just what, exactly, is the accounting information system? Is it a room full of computers and papers? Not necessarily. The accounting information system consists of data, papers to support the data, machines to process the data, and most importantly, people to report the resulting information to those who make decisions based on such information. Every organization that is engaged in transactions needs an accounting information system. This brings us to an important term used in accounting—a transaction! But what, exactly, is a transaction?
Identifying Business Transactions
A transaction is any event that involves an exchange or consumption of resources. A transaction could take place between a company and external parties (e.g., purchase of raw materials from suppliers or sale of merchandise to customers), or within a company itself (e.g., a company uses supplies that were purchased at a previous date and were held as an asset called Supplies until the date of use). Both events are recordable in the books of the organization.
A Transaction Is an Economic Event
A transaction is an economic event that alters the financial position of the entities engaging in it. For example, when a company purchases a machine (or uses the services of another business) either by using its cash or on credit, it acquires a new item (or incurs an expense) and simultaneously depletes its cash or incurs a liability. That is a transaction! Simply placing an order with a vendor or hiring an employee is not recorded as a transaction.
Every transaction has an impact on the accounting equation of the company. If you recall from Week 1, the accounting equation is what keeps a balance sheet balanced. The equation looks like this:
ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY
Accounting is transaction-based, so whenever an event occurs, we analyze its impact on the accounting equation and record it accordingly in the books of accounts. Some examples of such events are:
1. A group of people (stockholders) invests $100,000 in a company. This will cause cash to increase ASSETS on the left side of the equation, and common stock capital will increase EQUITY on the right side of the equation. After this transaction is recorded, the accounting equation is still in balance.
2. The company purchases office equipment for $10,000. At the time of purchase, $5,000 cash is paid in a down payment and the balance is payable after 90 days. ASSETS on the left side of the equation increase by $10,000 in the form of the equipment and decrease by $5,000 in the form of cash. This results in a NET increase of $5,000 on the left side of the equation, which then is balanced by an increase of $5,000 in accounts payable (or notes payable) LIABILITIES on the right side. Thus, a transaction may affect more than one account on each or either side of the equation.
3. The company hires a CEO who will be making $300,000 per year. In this case, there is no transaction on the date of the hiring, because there has been no exchange of resources or services. Nothing will be recorded in the books until the CEO has performed services.
What is described above is referred to as a transaction analysis, and it will look like this:
Cash + Office Equip = LIABILITIES
Accounts/Notes Payable + STOCKHOLDERS’ EQUITY
(1) +100,00 +100,000
(2) -5,000 + 10,000 +5,000
(3) Not an accounting transaction
Illustration 3-3 on page 110 of your textbook is a good example of how different transactions affect the accounting equation.
Now we have to find a way to record transactions in the books. This is where the accounting information system starts functioning. All transactions are first recorded in the journal and then posted (transferred) to the appropriate accounts in the ledger. An account is a summary of transactions pertaining to any item, wherein the item could be an asset (e.g., cash), liability (e.g., amounts due to suppliers), revenue (e.g., sales), expense (e.g., salaries to employees), or owners’ equity (e.g., capital stock). A collection of all accounts in one place is called a ledger. Transactions are entered into the journal and posted to the ledger by following certain rules.
Rules of Debit and Credit
1. Accounts on the left side of the accounting equation (to the left of the “=” sign) are increased by debits (abbreviation DR) and decreased by credits (abbreviation CR).
2. Accounts on the right side of the accounting equation are increased by credits and decreased by debits.
The words debit and credit do not have any special meaning other than what is described above. Remember that these are just tools for recording information in the books of accounts.
Increases and decreases in assets and liabilities are easy to follow.
As for owners’ equity:
• Equity increases because of either of two reasons:
o Whenever the owners make additional investments of resources into the business
o The business earns revenues
• Further, equity decreases because of either of two reasons:
o Whenever the owners withdraw resources from the business (e.g., in the form of dividends paid to stockholders, or in the case of a single-owner business when the owner withdraws cash from the business)
o The business incurs an expense
Remember the interrelationships of the financial statements from Illustration 1-9 on page 17?
Net income (i.e., revenues–expenses) from the income statement flows to the retained earnings statement and then into owners’ equity. Therefore, (revenue–expenses) it is shown under the stockholders’ equity section of the accounting equation.
Common Stock + Retained Earnings + (Revenue–Expenses) – Dividends
Click here to open the Algebra Review
Rules of Debt and Credit
Rules of Debit and Credit
This Drag-and-Drop activity provides you with an opportunity to practice rules of debit and credit with regards to different accounts.
Therefore, the accounting equation may be written as:
Assets = Liabilities + [Common Stock + Retained Earnings + (Revenue – Expenses) – Dividends]
Revenues increase stockholders’ equity via retained earnings. Retained earnings have a credit balance, so revenues are increased by credits. Expenses decrease stockholders’ equity via retained earnings, which means expenses are increased by debits.
Illustration 3-16 on page 116 of your textbook nicely summarizes the rules of debit and credit for different categories of the items in the financial statements. It will be a good idea to refer to that illustration from time to time until you memorize the rules.
Journal, Ledger Accounts, and Trial Balance Every transaction is first entered into a journal and then transferred or posted to the appropriate accounts affected by the transaction.
For a transaction involving the Balance Sheet accounts, we can record the changes using a three-step process. Click the picture to view an interactive demo. (Note: this tutorial requires sound.)
You may ask, why record the information in two places, namely, once in the journal and then again in the ledger? A journal keeps a chronological record of business transactions as those transactions happen, so you always know which transactions took place on a given day. However, if you want to know the information about a specific item, such as how much rent was paid during the year or how much interest was received during the quarter, you cannot get that information from the journal. For that, you have to look at the rent expense account or interest revenue account in the ledger, where the information is sorted and posted to the specific accounts.
For the accounting information to be eventually reported in the financial statements, we have to know the total amount under each specific asset, liability, revenue, expense, and owners’ equity item. Here we are talking about finding the balance of each account! The balance in each account is found by comparing the total of its debit side with the total of its credit side. If the debit side total is greater than the credit side total, we say that the account has a debit balance. If the credit side total is greater than the debit side total, we say that the account has a credit balance.
Normal Balance of an Account
The normal balance of an account is influenced by whether we debit or credit that account for the increase in the account. Thus, an asset account has a normal debit balance, but a liability account has a normal credit balance.
A trial balance is a listing of all accounts and their balances at the end of a period. The preparation of a trial balance is the starting point in the process to prepare the financial statements, and therefore a trial balance may be prepared monthly, quarterly, or annually, depending on how often the company prepares its financial statements.
The trial balance shows that the total of the debit amounts equals the total of the credit amounts, but it does not ensure that all transactions have been recorded or that all transactions have been recorded correctly. For example, rent expense could have been debited (instead of utility expense) when the utility bill was paid. In this case, the trial balance would be in balance, but the utility expense figure would be understated for the period, and rent expense would be overstated for the period. Also, a sale of merchandise may have been recorded two times or may not have been recorded at all. Yet, it will not affect the trial balance total. That’s why we need more checks and balances within the company to ensure that such errors and omissions are detected and corrected on a timely basis.
Please note the order of the accounts on the trial balance. The balance sheet accounts of assets, liabilities, and stockholders’ equity are listed first, and then the income statement accounts of revenue and expense are listed.
Cash-Basis Versus Accrual-Basis Accounting Some businesses follow the cash-basis accounting approach, in which revenue is recorded only when it is received in cash, and an expense is recorded only when it is paid in cash. Under this approach, there are no receivables or payables in the accounts. Most small businesses may follow this approach. Large and publicly traded companies, however, cannot follow this approach because it is not in conformity with the generally accepted accounting principles (remember, you heard this term in Week 1!). Publicly traded companies have to follow the accrual-basis accounting approach.
Under accrual accounting, revenue is recorded when it is earned, regardless of the timing of its receipt, and an expense is recorded when it is incurred, regardless of when it is paid. The accrual-basis approach records revenues and expenses based on the happening of those events, independent of when cash comes in or goes out.
Though smaller, private businesses are not required to use accrual-basis accounting, they still may choose to use it under certain circumstances. Can you guess when that might happen? We will discuss this in the Discussion area.
Accrual Accounting Concepts Revenue Recognition Principle
According to this principle, revenue is recognized (recorded in the books) when it is earned, and revenue is earned when there is an exchange of goods, or the performance of services is complete or virtually complete. For example, if you have a furniture-making business in which you sell on credit, you can record revenue when you make and ship the furniture to your customers, even if they will not pay until after 30 days or so from the time of the shipment. Also, if you are in the business of painting houses, you earn your revenue when you finish painting a house. You can record the revenue even if you have not formally sent an invoice to the customer, as long as you have finished the work and the customer has approved it. Note that, in this case, the revenue is realizable because you have a promise from your customer that he or she will honor your invoice in return for the goods or services that they have accepted from you. Of course, you may not record the revenue if there is a significant doubt about whether you will be able to collect the money from the customer after providing them goods or services. This could happen if, right after painting a customer’s house, the house is burned down and the customer has no money to pay.
Revenue recognition is a very important area and has been a subject of discussion in recent years. Can you guess why? According to a study sponsored by the U.S. Government Accountability Office, a large number of companies have ended up restating their financial statements in the past few years because of making “mistakes” in recording revenue. Have you read about companies that allegedly made errors in recording their yearly revenues? If so, please remember to bring that up at the right time when we discuss it in the Discussion area this week.
Another important accounting principle that has a profound impact on the income statement of a company is the matching principle. According to this principle, in order to calculate the net income correctly, expenses should be matched with those revenues that are deemed to result from the incurring of those expenses. Thus, when calculating the net income, cost of goods sold is subtracted from sales, and sales commission is subtracted as an expense from sales, and so forth.
However, sometimes such direct matching is not possible. In that situation, expenses are matched with the revenues of the period in which those expenses are incurred. For example, expenses like salaries of administrative employees, depreciation on office equipment and building(s), and income tax cannot be associated directly with any specific revenues. Hence such expenses are reported on the income statement of the period in which these expenses are incurred.
Time Period Assumption
If you started a business with $100,000 in 1988 and closed the business at the end of 2008 with the owners’ equity showing a balance of $150,000,000, then the total income of the business over its life would be $150,000,000 – $100,000 = $149,900,000. However, if your business is also co-owned by other people (e.g., stockholders), they are not going to wait for 20 years to find out if their investments made a profit or were a loss for them. It is a common practice, therefore, to divide the life of a business into 12 monthly periods, called the accounting year, and prepare financial statements for each such accounting year. Publicly traded companies are required to publish their financial results every quarter, in addition to publishing their annual financial statements. Because it is important to know how your business is doing on a continual basis, most public and many private companies prepare their financial statements on a monthly basis for their internal uses.
Adjusting Entries, Adjusted Trial Balance, and Closing Adjusting Entries
A direct result of using the accrual-basis approach to accounting is that whenever we are ready to prepare financial statements, we have to make adjusting entries in the books so that all assets, liabilities, revenues, and expenses reflect their most up-to-date amounts.
Note that accrual accounting requires us to record revenue when it is earned (regardless of when it is received) and record an expense when it is incurred (regardless of when it is paid). Thus, under accrual accounting, there comes a time when we record revenue and in the absence of a simultaneous cash receipt, also record a receivable (an asset). Likewise, there may be a time when we record an expense and in the absence of a simultaneous cash payment, also record a payable (a liability). In addition, there are times when a business may receive money in advance of earning it (e.g., receiving subscriptions from customers before delivering magazines) or pay expenses before incurring them (e.g., prepaying insurance premium or rent several months in advance), thus creating unearned revenues (a liability) or prepaid expenses (an asset). If, around the time of the preparation of the financial statements, circumstances indicate that there may be some unrecorded revenues or expenses or unearned revenues and prepaid expenses, we have to employ adjusting entries to record such revenues and expenses and adjust the corresponding assets and liabilities. Not making such adjusting entries on a timely basis misstates revenues and expenses, and affects net income for the period.
Illustrations 4-3 on page 168 and Illustration 4-23 on page 181 together provide good summaries of the four types of adjusting entries that may be found in any company’s books. It should be noted that it may not be necessary to make each of the four types of adjusting entries in every accounting period. The choice of the entry depends on the circumstances of each case. For example, if there are no prepaid expenses in a period, there is no need to make an entry for showing the expiration of the prepayment.
Points to Remember About Adjusting Entries
An adjusting entry is made because a revenue or expense is being recorded without a simultaneous cash receipt or payment or to show the expiration of an advance receipt or prepayment of a revenue or expense, respectively. Thus, at the time of an adjusting entry, there is no exchange of cash.
Also, every adjusting entry involves one revenue or expense, and one asset or liability.
For additional information regarding adjusting journal entries, please review the tutorial below:
Adjusting Entries Tutorial
One of the key advantages of an accounting information system is the automated nature of the financial statements. Because the financial statements are adjusted with every journal entry and every change in the chart of accounts, it is easy to see how the entries that you make impact the statements. At the same time, the financial statements are intimately interconnected. When one changes, the others change as well. A lot of students really like learning Peachtree for this reason. They begin to see how all of the different parts of an accounting system fit together.
Click on the link below to open the tutorial, and click the buttons in the tutorial to learn more about adjusting entries. Adjusting Entries
Adjusted Trial Balance
After the adjusting entries are posted to the appropriate ledger accounts, all accounts are balanced, and once again a revised trial balance, called an adjusted trial balance, is prepared. This adjusted trial balance becomes the source of information for preparing the income statement and balance sheet
Closing Entries and the Closing Process
The revenue accounts, expense accounts, and dividend accounts are called temporary accounts because these exist only to arrive at the net income figure for the year and update the retained earnings balance, which then is merged into owners’ equity. Once the financial statements have been prepared, closing entries are made and posted to close the temporary accounts. At that point, all revenues, expenses, and dividend accounts show zero balances. Thus we begin each new year with zero amounts in revenues, expenses, and dividends. Then the post-closing trial balance is prepared. On the post-closing trial balance, you will find only the permanent accounts such as assets, liabilities, and stockholders’ equity accounts (capital and retained earnings).
The rules of Revenue Recognition are similar under GAPP and IFRS. Revenue is recognized when it is both realized and earned, but not necessarily when the cash is paid. The biggest difference is GAAP details when to recognize revenue with specifics by revenue type and industry. This form of regulation is known as prescriptive rules. Under IFRS, there are more general rules with a single standard and general principles and examples.
Self-Assessment Let’s see how much you learned from the information above. It’s time for the Self-Test. Click here to find the Self-Tests. Click on Chapter 3 and complete the questions. When you are finished with Chapter 3, go on to Chapter 4. You may take the Additional Self-Tests by clicking here. Again, you can complete Chapter 3, and then proceed to Chapter 4.