5 ADJUSTING CLOSING PROCESS 1 Accounting Cycle Basic Steps a Record transactions in the journal b Post from the journal to the ledger c Prepare an unadjusted trial balance d Record and post year end adjusting entries e Prepare an adjusted trial balance f From the adjusted trial balance prepare financial statements 2 Accrual Accounting a Revenues recorded when earned b Expenses recorded in the same period they help to earn revenues when they are incurred c Required by GAAPP 1 Adjusting Entries Needed to ensure that the realization principal and matching concept are followed a They are journal entries made at the end of an accounting period year or month to update account balances b These adjusting entries are required because of accrual accounting recording revenues and expenses at a time OTHER than cash receipt or cash disbursement and are required each time financial statements are prepared c Two Main Categories of Adjustments i Deferrals Transactions for which cash has been received or paid while the related revenue or expense has not been recorded exchange of cash before the action 1 Deferred Expenses Prepaid Expenses Company pays for an expense item in advance This pre pyment is recorded as an asset and only becomes an expense when it is used up Prepaid rent Prepaid insurance 2 Deferred Revenue Unearned Revenue I Company receives cash in advance for services to be formed or goods to be delivered later This cash received is recorded as a liability It only becomes a revenue when it is earned when the company actually performs the service or delivers the good ii Accruals Transactions for which cash has not yet been received or paid but the related revenue or expense has been earned or incurred and thus must be recorded action has a occurred before the exchange of cash iii Supplies When purchases supplies are classified as an asset specifically a current asset 1 Once they are used up in the course of business they are considered an expense supplies expense 2 Accruals Transaction for which cash has not yet been received or paid but the related revenue or expense has been earned or incurred and thus must be recorded Action before exchange of cash a Accrued Revenues Revenues earned but not yet received in cash or i Debit an asset account and credit a revenue account b Accrued Expenses Expenses incurred but not yet paid in cash or recorded recorded i Debit an expense account and credit a liability account 3 Depreciation has ABSOLUTELY NOTHING to do with the value of an asset This is very counter intuitive We DO NOT depreciate an asset because its value is decreases a The Matching Concept b Depreciation Expense Classified as an expense account i Found on the income statement ii Reduces net income iii Represents the amount of the building or equipment used up in the current year c Accumulated Depreciation i Causes a decreases in assets ii Classified as a contra asset account reduction of my assets iii Normal balance is cred iv Found on the balance sheet directly underneath the asset being depreciated v Represent the total amount of the building or equipment used up since it was acquired by the company vi Annual Depreciation Expesne cost Residual value Useful 4 Interest Principal x Rate x Time ACCRUAL life a KEY POINTS i Rate always expressed as an annual rate ii Time is always a fraction over 12 iii Interest can be computed for any time period less than or equal to one year but never more than one year iv All interest is repaid a the end of a lon Interest Expense Borrow money and repay it Interest Revenue Lend money and repaid interest b c SUMMARY OF ADJUSTING ENTRIES TYPE OF ADJUSTMENT Prepaid Expense Unearned Revenue Accrued Revenue Accrued Expense ACCOUNT RELATIONSHIP ADJUSTING ENTRY Assets and Expenses Liabilities and Revenues Assets and Revenue Expenses and Liabilities D Expenses D Liabilities D Assets D Expenses 1 Adjusted Trial Balance a Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted b The purpose is to prove the equality of the total debit and c credit balances in the ledger after all adjustments have been made It is the same thing as the unadjusted trial balance a listing of accounts with their balance except it includes the effects of adjusting entries d Financial statements can be prepared directly form the adjusted trial balance 2 Record closing entries a Nominal temporary Account are closed to a zero balance at the end of the year revenues expenses dividends b Permanent real Accounts are never closed to zero as part of the year end closing process assets liabilities equity c THREE CLOSING ENTRIES NEED TO BE MADE i Close revenues into RE ii Close expenses into RE iii Close dividends into RE d After closing entries are posted i All temporary accounts have 0 balances ii The balance in RE represents the accumulated undistributed earnings at the ned of the accounting period That is the balance in RE represents the net income earned by the company that has not been paid out as dividends to stockholders