Completing the Accounting Cycle

Chapter 4 discusses issues that deal with your internal accounting system, and are not necessarily relevant to the use and interpretation of financial accounting statements, which are the end product of the accounting system.

I would describe that accounting process, or cycle, like this:

1. Is there a transaction? Do we recognize this transaction? That is, does the transaction meet the tests we discussed in Chapter 2?

2. If there is a transaction, then that financial event is structured as a journal entry, with a date, account and amount to be debited, account and amount to be credited, and an explanation that refers to a source document, such as an invoice, check number, etc, to create a paper trail. The rules of debits and credits apply, ergo DEBITS = CREDITS.

3. Periodically, the information chronological record of transactions must be transferred to the general ledger, which is where the account balances are held. The posting process, on a non-computerized system, is tedious and routinized, yet is critical to the integrity of the information produced, that is, the financial statements.

4. The first step in preparing financial statements is to transfer and organize the account balance information in the general ledger in trial balance form, in order to prove that DEBITS = CREDITS.

5. Then, that trial balance must be adjusted for those internal transactions, accruals and deferrals. Source documents include internal counts of supplies, analysis of contracts such as insurance, employee time records, etc. Then, the adjustments are recorded in the general journal and posted to the general ledger. Finally, an adjusted trial balance is prepared from which financial statements are prepared and delivered to the statement users.

6. After the preparation of statements, closing entries are prepared and posted to accomplish several objectives.

First, the closing entries funnel the results of operations into stockholders' equity via the retained earnings account. Second, the closing entries close, that is reduce to a zero balance, the temporary accounts, that is, those accounts whose balances do not transcend the end of a fiscal period.

Think about it. Your cash account, which is an asset, or your liability accounts have the same balance on December 31 as they do after New Year’s, on January 1. But, your revenue and expense accounts have balances that reflect the accumulation of transactions throughout the fiscal period up to December 31. On January 1, the accountant records transactions that are the equivalent of setting the odometer (the “trip-o-meter”) on your car back to zero when you fill it with gas. The closing transactions are listed below:

1. Close Revenue Accounts into Income Summary
Debit Revenue accounts, credit Income Summary

2. Close Expense Accounts into Income Summary
Debit Income Summary, credit Expense Accounts

3. Close Income Summary into Owner’s Capital
If net income, Debit Income Summary, credit Retained Earnings
If net loss, Debit Owner’s capital, credit Income Summary

4. Close Withdrawals into Owner’s Capital
Debit Owner’s Capital, credit Withdrawals.

On a manual system, an accountant prepares a work sheet - a tool for preparing financial statements that involves a long piece of paper with lots of little boxes to fill in with numbers that are easy to transpose and slide. (Exhibit 8 on page #144)

Here are the steps to complete that work sheet:

1. Trial Balance - Debits = Credits!!!
2. Adjustments - Affect one balance sheet and one income statement account
3. Adjusted Trial Balance - Debits = Credits after effects of adjustments are made to accounts
4. Preparation of Financial Statements -
On income statement columns, revenues are credits and expenses are debits.
If debits > credits, net loss; If credits > debits, net income.

On balance sheet columns, assets and withdrawals are debits;
contra assets, liabilities, common stock, owner’s capital are credits

If debits > credits, net income;
If credits > debits, net loss.

Financial statement columns are balanced with the results of operations.

Finally, a post closing trial balance is prepared. The PCTB is a trial balance of all Permanent Accounts to prove that Debits = Credits.

Post-closing Trial Balance

Assets	=	Liabilities
	+	Contra Assets
	+	Owner’s capital

Debits	=	Credits

That’s it! Once the books have been closed for the fiscal year, the accounting cycle is completed and the accountants’ work is done for the year. The time is approximately 11:45 p.m. on December 31, and the New Year’s Eve party is out of control, the salespeople are long gone, the potato chips and cheetos are soggy, but the accountants are content with the world, order has been produced from chaos, and debit equal credits.

Incidentally, I’ll never ask you to prepare a work sheet for homework or an exam, and I won’t ask you about reversing entries. For the curious, a reversal is simply a bookkeeping trick to back off an accrual adjustment so that the next transaction that affects those accounts (wages expense, for example), can be recorded without worrying about how much of an asset or liability was accrued in the adjustment process.

Clifford