ACC502 Grand Canyon University Adjusting Journal Entries Paper Review the available materials for the chapters covered this week, including the lecture, re
ACC502 Grand Canyon University Adjusting Journal Entries Paper 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
The 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
There 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).
The accrual 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).
The 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
The 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.
Adjusting 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.
All 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 management.
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
The 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.
The 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
Owners’ 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 sheet.
The 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
The 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
After 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.
Revenues, 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.
Closing 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 account.
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.
The 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 sheet.
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