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Principles of Accounting, Volume 1: Financial Accounting

5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business

Principles of Accounting, Volume 1: Financial Accounting5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

We have gone through the entire accounting cycle for Printing Plus with the steps spread over three chapters. Let’s go through the complete accounting cycle for another company here. The full accounting cycle diagram is presented in Figure 5.14.

A large circle labeled, in the center, The Accounting Cycle. The large circle consists of 10 smaller circles with arrows pointing from one smaller circle to the next one. The smaller circles are labeled, in clockwise order: 1 Identify and Analyze Transactions; 2 Record Transactions to Journal; 3 Post Journal Information to Ledger; 4 Prepare Unadjusted Trial Balance; 5 Adjusting Entries; 6 Prepare Adjusted Trial Balance; 7 Prepare Financial Statements; 8 Closing Entries; 9 Prepare Post-Closing Trial Balance; 10 Reversing Entries (optional).
Figure 5.14 The Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

We next take a look at a comprehensive example that works through the entire accounting cycle for Clip’em Cliff. Clifford Girard retired from the US Marine Corps after 20 years of active duty. Cliff decides it would be fun to become a barber and open his own shop called “Clip’em Cliff.” He will run the barber shop out of his home for the first couple of months while he identifies a new location for his shop.

Since his Marines career included several years of logistics, he is also going to operate a consulting practice where he will help budding barbers create a barbering practice. He will charge a flat fee or a per hour charge. His consulting practice will be recognized as service revenue and will provide additional revenue while he develops his barbering practice.

He obtains a barber’s license after the required training and is ready to open his shop on August 1. Table 5.2 shows his transactions from the first month of business.

Transactions for August
Date Transaction
Aug. 1 Cliff issues $70,000 shares of common stock for cash.
Aug. 3 Cliff purchases barbering equipment for $45,000; $37,500 was paid immediately with cash, and the remaining $7,500 was billed to Cliff with payment due in 30 days. He decided to buy used equipment, because he was not sure if he truly wanted to run a barber shop. He assumed that he will replace the used equipment with new equipment within a couple of years.
Aug. 6 Cliff purchases supplies for $300 cash.
Aug. 10 Cliff provides $4,000 in services to a customer who asks to be billed for the services.
Aug. 13 Cliff pays a $75 utility bill with cash.
Aug. 14 Cliff receives $3,200 cash in advance from a customer for services not yet rendered.
Aug. 16 Cliff distributed $150 cash in dividends to stockholders.
Aug. 17 Cliff receives $5,200 cash from a customer for services rendered.
Aug. 19 Cliff paid $2,000 toward the outstanding liability from the August 3 transaction.
Aug. 22 Cliff paid $4,600 cash in salaries expense to employees.
Aug. 28 The customer from the August 10 transaction pays $1,500 cash toward Cliff’s account.
Table 5.2

Transaction 1: On August 1, 2019, Cliff issues $70,000 shares of common stock for cash.

Analysis:

  • Clip’em Cliff now has more cash. Cash is an asset, which is increasing on the debit side.
  • When the company issues stock, this yields a higher common stock figure than before issuance. The common stock account is increasing on the credit side.
Journal entry for August 1, 2019 debiting Cash and crediting Common Stock for 70,000. Explanation: “To recognize issuance of common stock.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 70,000 equals Liabilities don’t change plus Equity goes up 70,000. 70,000 equals 0 plus 70,000.

Transaction 2: On August 3, 2019, Cliff purchases barbering equipment for $45,000; $37,500 was paid immediately with cash, and the remaining $7,500 was billed to Cliff with payment due in 30 days.

Analysis:

  • Clip’em Cliff now has more equipment than before. Equipment is an asset, which is increasing on the debit side for $45,000.
  • Cash is used to pay for $37,500. Cash is an asset, decreasing on the credit side.
  • Cliff asked to be billed, which means he did not pay cash immediately for $7,500 of the equipment. Accounts Payable is used to signal this short-term liability. Accounts payable is increasing on the credit side.
Journal entry for August 3, 2019 debiting Equipment for 45,000 and crediting Cash for 37,500 and Accounts Payable for 7,500. Explanation: “To recognize purchase of equipment.” Assets equal Liabilities plus Stockholders’ Equity. Assets go up 45,000 and go down 37,500 equals Liabilities go up 7,500 plus Equity doesn’t change. 7,500 equals 7,500 plus 0.

Transaction 3: On August 6, 2019, Cliff purchases supplies for $300 cash.

Analysis:

  • Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
  • Supplies, an asset account, is increasing on the debit side.
Journal entry for August 6, 2019 debiting Supplies and crediting Cash for 300. Explanation: “To recognize supplies purchase.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 300 and go down 300 equals Liabilities don’t change plus Equity doesn’t change. 0 equals 0 plus 0.

Transaction 4: On August 10, 2019, provides $4,000 in services to a customer who asks to be billed for the services.

Analysis:

  • Clip’em Cliff provided service, thus earning revenue. Revenue impacts equity, and increases on the credit side.
  • The customer did not pay immediately for the service and owes Cliff payment. This is an Accounts Receivable for Cliff. Accounts Receivable is an asset that is increasing on the debit side.
Journal entry for August 10, 2019 debiting Accounts Receivable and crediting Service Revenue for 4,000. Explanation: “To recognize revenue earned, customer purchased on account.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 4,000 equals Liabilities don’t change plus Equity goes up 4,000. 4,000 equals 0 plus 4,000.

Transaction 5: On August 13, 2019, Cliff pays a $75 utility bill with cash.

Analysis:

  • Clip’em Cliff now has less cash than before. Cash is an asset that is decreasing on the credit side.
  • Utility payments are billed expenses. Utility Expense negatively impacts equity, and increases on the debit side.
Journal entry for August 13, 2019 debiting Utilities Expense and crediting Cash for 75. Explanation: “To recognize payment of utility bill.” Assets equals Liabilities plus Stockholders’ Equity Assets go down 75 equals Liabilities don’t change plus Equity goes down 75. Minus 75 equals 0 plus (minus 75).

Transaction 6: On August 14, 2019, Cliff receives $3,200 cash in advance from a customer for services to be rendered.

Analysis:

  • Clip’em Cliff now has more cash. Cash is an asset, which is increasing on the debit side.
  • The customer has not yet received services but already paid the company. This means the company owes the customer the service. This creates a liability to the customer, and revenue cannot yet be recognized. Unearned Revenue is the liability account, which is increasing on the credit side.
Journal entry for August 14, 2019 debiting Cash 3,200 and crediting Unearned Revenue for 3,200. Explanation: “To recognize customer’s advanced payment.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 3,200 equals Liabilities go up 3,200 plus Equity doesn’t change. 3,200 equals 3,200 plus 0.

Transaction 7: On August 16, 2019, Cliff distributed $150 cash in dividends to stockholders.

Analysis:

  • Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
  • When the company pays out dividends, this decreases equity and increases the dividends account. Dividends increases on the debit side.
Journal entry for August 16, 2019 debiting Dividends and crediting Cash for 150. Explanation: “To recognize distribution of dividends.” Assets equals Liabilities plus Stockholders’ Equity. Assets go down 150 equals Liabilities don’t change plus Equity goes down 150. Minus 150 equals 0 plus (minus 150).

Transaction 8: On August 17, 2019, Cliff receives $5,200 cash from a customer for services rendered.

Analysis:

  • Clip’em Cliff now has more cash than before. Cash is an asset, which is increasing on the debit side.
  • Service was provided, which means revenue can be recognized. Service Revenue increases equity. Service Revenue is increasing on the credit side.
Journal entry for August 17, 2019 debiting Cash and crediting Service Revenue for 5,200. Explanation: “To recognize revenue earned.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 5,200 equals Liabilities don’t change plus Equity goes up 5,200. 5,200 equals 0 plus 5,200.

Transaction 9: On August 19, 2019, Cliff paid $2,000 toward the outstanding liability from the August 3 transaction.

Analysis:

  • Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
  • Accounts Payable is a liability account, decreasing on the debit side.
Journal entry for August 19, 2019 debiting Accounts Payable and crediting Cash for 2,000. Explanation: “To recognize partial payment of liability.” Assets equals Liabilities plus Stockholders’ Equity. Assets go down 2,000 equals Liabilities go down 2,000 plus Equity doesn’t change. Minus 2,000 equals minus 2,000 plus 0.

Transaction 10: On August 22, 2019, Cliff paid $4,600 cash in salaries expense to employees.

Analysis:

  • Clip’em Cliff now has less cash. Cash is an asset, which is decreasing on the credit side.
  • When the company pays salaries, this is an expense to the business. Salaries Expense reduces equity by increasing on the debit side.
Journal entry for August 22, 2019 debiting Salaries Expense and crediting Cash for 4,600. Explanation: “To recognize employee salary payment.” Assets equals Liabilities plus Stockholders’ Equity. Assets go down 4,600 equals Liabilities don’t change plus Equity goes down 4,600. Minus 4,600 equals 0 plus (minus 4,600).

Transaction 11: On August 28, 2019, the customer from the August 10 transaction pays $1,500 cash toward Cliff’s account.

Analysis:

  • The customer made a partial payment on their outstanding account. This reduces Accounts Receivable. Accounts Receivable is an asset account decreasing on the credit side.
  • Cash is an asset, increasing on the debit side.
Journal entry for August 28, 2019 debiting Cash and crediting Accounts Receivable for 1,500. Explanation: “To recognize customer partial payment.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 1,500 and go down 1,500 equals Liabilities don’t change plus Equity doesn’t change. 0 equals 0 plus 0.

The complete journal for August is presented in Figure 5.15.

Journal entries. August 1, 2019 debit Cash and credit Common Stock for 70,000. August 3, 2019 debit Equipment for 45,000 and credit Cash for 37,500 and Accounts Payable for 7,500. August 6, 2019 debit Supplies and credit Cash for 300. August 10, 2019 debit Accounts Receivable and credit Service Revenue for 4,000. August 13, 2019 debit Utilities Expense and credit Cash for 75. August 14, 2019 debit Cash 3,200 and credit Unearned Revenue for 3,200. August 16, 2019 debit Dividends and credit Cash for 150. August 17, 2019 debit Cash and credit Service Revenue for 5,200. August 19, 2019 debit Accounts Payable and credit Cash for 2,000. August 22, 2019 debit Salaries Expense and credit Cash for 4,600. August 28, 2019 debit Cash and credit Accounts Receivable for 1,500.
Figure 5.15 Journal Entries for August. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Once all journal entries have been created, the next step in the accounting cycle is to post journal information to the ledger. The ledger is visually represented by T-accounts. Cliff will go through each transaction and transfer the account information into the debit or credit side of that ledger account. Any account that has more than one transaction needs to have a final balance calculated. This happens by taking the difference between the debits and credits in an account.

Clip’em Cliff’s ledger represented by T-accounts is presented in Figure 5.16.

Cash has an August 1 debit entry of 70,000, an August 3 credit entry of 37,500, an August 6 credit entry of 300, an v 13 credit entry of 75, a August 14 debit entry of 3,200, an August 16 credit entry of 150, an August 17 debit entry of 5,200, an August 19 credit entry of 2,000, an August 22 credit entry of 4,600, and an August 28 debit entry of 1,500, leaving a debit balance of 35,275. Accounts Receivable has an August 10 debit entry of 4,000, an August 28 credit entry of 1,500, and a debit balance of 2,500. Supplies has an August 6 debit entry of 300 and a debit balance of 300. Equipment has an August 3 debit entry of 45,000 and a debit balance of 45,000. Accounts Payable has an August 3 credit entry of 7,500, an August 19 debit entry of 2,000 and a credit balance of 5,500. Unearned Revenue has a credit August 14 entry of 3,200 and a credit balance of 3,200 Common Stock has an August 1 credit entry of 70,000 and a credit balance of 70,000. Dividends has an August 16 debit entry of 150, and a debit balance of 150. Service Revenue account has 2 entries on the credit side: August 10 4,000, and Aug 17 5,200. The total on the credit side is then 9,200. Salaries Expense has an August 22 debit side entry for 4,600 and a debit side balance of 4,600. Utilities Expense has an August 13 debit side entry for 75, and a debit side balance of 75.
Figure 5.16 T-Accounts for August. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

You will notice that the sum of the asset account balances in Cliff’s ledger equals the sum of the liability and equity account balances at $83,075. The final debit or credit balance in each account is transferred to the unadjusted trial balance in the corresponding debit or credit column as illustrated in Figure 5.17.

Clip’em Cliff, Unadjusted Trial Balance, For the Month Ended August 31, 2019. Cash 35,275 debit. Accounts receivable 2,500 debit. Supplies 300 debit. Equipment 45,000 debit. Accounts Payable 5,500 credit. Unearned Revenue 3,200 credit. Common Stock 70,000 credit. Dividends 150 debit. Service Revenue 9,200 credit. Salaries Expense 4,600 debit. Utility Expense 75 debit. Total debits and credits are each 87,900. The ledger pages for Service Revenue and Salaries Expense are showing their balances being put into the Unadjusted Trial Balance as an example for all the balances.
Figure 5.17 Unadjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Once all of the account balances are transferred to the correct columns, each column is totaled. The total in the debit column must match the total in the credit column to remain balanced. The unadjusted trial balance for Clip’em Cliff appears in Figure 5.18.

Clip’em Cliff, Unadjusted Trial Balance, For the Month Ended August 31, 2019. Cash 35,275 debit. Accounts receivable 2,500 debit. Supplies 300 debit. Equipment 45,000 debit. Accounts Payable 5,500 credit. Unearned Revenue 3,200 credit. Common Stock 70,000 credit. Dividends 150 debit. Service Revenue 9,200 credit. Salaries Expense 4,600 debit. Utility Expense 75 debit. Total debits and credits are each 87,900.
Figure 5.18 Unadjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The unadjusted trial balance shows a debit and credit balance of $87,900. Remember, the unadjusted trial balance is prepared before any period-end adjustments are made.

On August 31, Cliff has the transactions shown in Table 5.3 requiring adjustment.

August 31 Transactions
Date Transaction
Aug. 31 Cliff took an inventory of supplies and discovered that $250 of supplies remain unused at the end of the month.
Aug. 31 The equipment purchased on August 3 depreciated $2,500 during the month of August.
Aug. 31 Clip’em Cliff performed $1,100 of services during August for the customer from the August 14 transaction.
Aug. 31 Reviewing the company bank statement, Clip’em Cliff discovers $350 of interest earned during the month of August that was previously uncollected and unrecorded. As a new customer for the bank, the interest was paid by a bank that offered an above-market-average interest rate.
Aug. 31 Unpaid and previously unrecorded income taxes for the month are $3,400. The tax payment was to cover his federal quarterly estimated income taxes. He lives in a state that does not have an individual income tax
Table 5.3

Adjusting Transaction 1: Cliff took an inventory of supplies and discovered that $250 of supplies remain unused at the end of the month.

Analysis:

  • $250 of supplies remain at the end of August. The company began the month with $300 worth of supplies. Therefore, $50 of supplies were used during the month and must be recorded (300 – 250). Supplies is an asset that is decreasing (credit).
  • Supplies is a type of prepaid expense, that when used, becomes an expense. Supplies Expense would increase (debit) for the $50 of supplies used during August.
Adjusting Journal entry for August 31, 2019 debiting Supplies Expense and crediting Supplies for 50. Explanation: “To recognize supplies usage for August.” Assets equals Liabilities plus Stockholders’ Equity. Assets go down 50 equals Liabilities don’t change plus Equity goes down 50. Minus 50 equals 0 plus (minus 50)

Adjusting Transaction 2: The equipment purchased on August 3 depreciated $2,500 during the month of August.

Analysis:

  • Equipment cost of $2,500 was allocated during August. This depreciation will affect the Accumulated Depreciation–Equipment account and the Depreciation Expense–Equipment account. While we are not doing depreciation calculations here, you will come across more complex calculations, such as depreciation in Long-Term Assets.
  • Accumulated Depreciation–Equipment is a contra asset account (contrary to Equipment) and increases (credit) for $2,500.
  • Depreciation Expense–Equipment is an expense account that is increasing (debit) for $2,500.
Adjusting Journal entry for August 31, 2019 debiting Depreciation Expense: Equipment and crediting Accumulated Depreciation: Equipment for 2,500. Explanation: “To recognize equipment depreciation for August.” Assets equals Liabilities plus Stockholders’ Equity. Assets go down 2,500 equals Liabilities don’t change plus Equity goes down 2,500. Minus 2,500 equals 0 plus (minus 2,500).

Adjusting Transaction 3: Clip’em Cliff performed $1,100 of services during August for the customer from the August 14 transaction.

Analysis:

  • The customer from the August 14 transaction gave the company $3,200 in advanced payment for services. By the end of August the company had earned $1,100 of the advanced payment. This means that the company still has yet to provide $2,100 in services to that customer.
  • Since some of the unearned revenue is now earned, Unearned Revenue would decrease. Unearned Revenue is a liability account and decreases on the debit side.
  • The company can now recognize the $1,100 as earned revenue. Service Revenue increases (credit) for $1,100.
Adjusting journal entry for August 31, 2019 debiting Unearned Revenue and crediting Service Revenue for 1,100. Explanation: “To recognize revenue earned from August 14 transaction.” Assets equals Liabilities plus Stockholders’ Equity. Assets don’t change equals Liabilities go down 1,100 plus Equity goes up 1,100. 0 equals minus 1,100 plus 1,100.

Adjusting Transaction 4: Reviewing the company bank statement, Clip’em Cliff identifies $350 of interest earned during the month of August that was previously unrecorded.

Analysis:

  • Interest is revenue for the company on money kept in a money market account at the bank. The company only sees the bank statement at the end of the month and needs to record as received interest revenue reflected on the bank statement.
  • Interest Revenue is a revenue account that increases (credit) for $350.
  • Since Clip’em Cliff has yet to collect this interest revenue, it is considered a receivable. Interest Receivable increases (debit) for $350.
Adjusting journal entry for August 31, 2019 debiting Interest Receivable and crediting Interest Revenue for 350. Explanation: “To recognize interest revenue earned but not yet collected.” Assets equals Liabilities plus Stockholders’ Equity. Assets go up 350 equals Liabilities don’t change plus Equity goes up 350. 350 equals 0 plus 350.

Adjusting Transaction 5: Unpaid and previously unrecorded income taxes for the month are $3,400.

Analysis:

  • Income taxes are an expense to the business that accumulate during the period but are only paid at predetermined times throughout the year. This period did not require payment but did accumulate income tax.
  • Income Tax Expense is an expense account that negatively affects equity. Income Tax Expense increases on the debit side.
  • The company owes the tax money but has not yet paid, signaling a liability. Income Tax Payable is a liability that is increasing on the credit side.
Adjusting journal entry for August 31, 2019 debiting Income Tax Expense and crediting Income Tax Payable for 3,400. Explanation: “To recognize taxes incurred but not yet paid.” Assets equals Liabilities plus Stockholders’ Equity. Assets don’t change equals Liabilities go up 3,400 plus Equity goes down 3,400. 0 equals 3,400 plus (minus 3,400).

The summary of adjusting journal entries for Clip’em Cliff is presented in Figure 5.19.

Journal entries: August 31, 2019 debit Supplies Expense, credit Supplies 50. August 31, 2019 debit Depreciation Expense: Equipment, credit Accumulated Depreciation: Equipment 2,500. August 31, 2019 debit Unearned Revenue, credit Service revenue 1,100. August 31, 2019 debit Interest Receivable, credit Interest revenue 350. August 31, 2019 debit Income Tax Expense, credit Income Tax Payable 3,400.
Figure 5.19 Adjusting Journal Entries for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Now that all of the adjusting entries are journalized, they must be posted to the ledger. Posting adjusting entries is the same process as posting the general journal entries. Each journalized account figure will transfer to the corresponding ledger account on either the debit or credit side as illustrated in Figure 5.20.

Journal entry August 31, 2019 debit Supplies Expense, credit Supplies 50. There is an arrow from the debit 50 to the page from the Supplies Expense ledger account where that debit is shown on the debit side. There is an arrow from the credit 50 to the page from the Supplies ledger account where that credit is shown on the credit side (along with the August 6 debit of 300, resulting in a new balance of 250.
Figure 5.20 Posting Ledger Entries for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

We would normally use a general ledger, but for illustrative purposes, we are using T-accounts to represent the ledgers. The T-accounts after the adjusting entries are posted are presented in Figure 5.21.

T-Accounts. Cash has an August 1 debit entry of 70,000, an August 3 credit entry of 37,500, an August 6 credit entry of 300, an August 13 credit entry of 75, a August 14 debit entry of 3,200, an August 16 credit entry of 150, an August 17 debit entry of 5,200, an August 19 credit entry of 2,000, an August 22 credit entry of 4,600, and an August 28 debit entry of 1,500, leaving a debit balance of 35,275. Accounts Receivable has an August 10 debit entry of 4,000, an August 28 credit entry of 1,500, and a debit balance of 2,500. Interest Receivable has an August 31 debit entry of 350 and a debit balance of 350. Supplies has an August 6 debit entry of 300, and August 31 credit entry of 50 and a debit balance of 250. Equipment has an August 3 debit entry of 45,000 and a debit balance of 45,000. Accumulated Depreciation has an August 31 credit entry of 2,500 and a credit balance of 2,500 Accounts Payable has an August 3 credit entry of 7,500, an August 19 debit entry of 2,000 and a credit balance of 5,500. Unearned Revenue has a credit August 14 entry of 3,200, an August 31 debit entry of 1,100 and a credit balance of 2,100. Income Tax Payable has an August 31 credit entry for 3,400 and a credit balance of 3,400. Common Stock has an August 1 credit entry of 70,000 and a credit balance of 70,000. Dividends has an August 16 debit entry of 150, and a debit balance of 150. Service Revenue account has 3 entries on the credit side: August 10 4,000, August 17 5,200, and August 31 of 1,100. The total on the credit side is then 10,300. Salaries Expense has an August 22 debit side entry for 4,600 and a debit side balance of 4,600. Utilities Expense has an August 13 debit side entry for 75, and a debit side balance of 75. Supplies Expense has a debit entry on August 31 of 50 and a debit balance of 50. Depreciation Expense: Equipment has a debit entry on August 31 of 2,500 and a debit balance of 2,500. Income Tax Expense has a debit entry on August 31 of 3,400 and a debit balance of 3,400.
Figure 5.21 Ledger Entries (in T-Accounts) for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

You will notice that the sum of the asset account balances equals the sum of the liability and equity account balances at $80,875. The final debit or credit balance in each account is transferred to the adjusted trial balance, the same way the general ledger transferred to the unadjusted trial balance.

The next step in the cycle is to prepare the adjusted trial balance. Clip’em Cliff’s adjusted trial balance is shown in Figure 5.22.

Clip’em Cliff, Unadjusted Trial Balance, For the Month Ended August 31, 2019. Cash 35,275 debit. Accounts receivable 2,500 debit. Interest receivable 350 debit. Supplies 250 debit. Equipment 45,000 debit. Accumulated Depreciation: Equipment 2,500 credit. Accounts Payable 5,500 credit. Unearned Revenue 2,100 credit. Income Tax Payable 3,400 credit. Common Stock 70,000 credit. Dividends 150 debit. Interest Revenue 350 credit. Service Revenue 10,300 credit. Supplies Expense 50 debit. Depreciation Expense: Equipment 2,500 debit. Income Tax Expense 3,400 debit. Salaries Expense 4,600 debit. Utility Expense 75 debit. Total debits and credits are each 94,150.
Figure 5.22 Adjusted Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The adjusted trial balance shows a debit and credit balance of $94,150. Once the adjusted trial balance is prepared, Cliff can prepare his financial statements (step 7 in the cycle). We only prepare the income statement, statement of retained earnings, and the balance sheet. The statement of cash flows is discussed in detail in Statement of Cash Flows.

To prepare your financial statements, you want to work with your adjusted trial balance.

Remember, revenues and expenses go on an income statement. Dividends, net income (loss), and retained earnings balances go on the statement of retained earnings. On a balance sheet you find assets, contra assets, liabilities, and stockholders’ equity accounts.

The income statement for Clip’em Cliff is shown in Figure 5.23.

Clip’em Cliff, Income Statement, For the Month Ended August 31, 2019. Revenues: Interest revenue $350, Service Revenue 10,300. Total Revenues $10,650. Expenses: Supplies Expense 50, Depreciation Expense: Equipment 2,500, Salaries Expense 4,600, Utilities Expense 75, Income Tax Expense 3,400. Total Expenses 10,625. Net Income $25.
Figure 5.23 Income Statement for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Note that expenses were only $25 less than revenues. For the first month of operations, Cliff welcomes any income. Cliff will want to increase income in the next period to show growth for investors and lenders.

Next, Cliff prepares the following statement of retained earnings (Figure 5.24).

Clip’em Cliff, Statement of Retained Earnings, For the Month Ended August 31, 2019. Beginning Retained earnings (August 1) $0, Net Income 25 less Dividends 150 equals Ending Retained Earnings (August 31) (125).
Figure 5.24 Statement of Retained Earnings for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The beginning retained earnings balance is zero because Cliff just began operations and does not have a balance to carry over to a future period. The ending retained earnings balance is –$125. You probably never want to have a negative value on your retained earnings statement, but this situation is not totally unusual for an organization in its initial operations. Cliff will want to improve this outcome going forward. It might make sense for Cliff to not pay dividends until he increases his net income.

Cliff then prepares the balance sheet for Clip’em Cliff as shown in Figure 5.25.

Clip’em Cliff, Balance Sheet, For the Month Ended August 31, 2019. Assets: Cash $35,275, Accounts receivable 2,500, Interest Receivable 350, Supplies 250, Equipment 45,000 less Accumulated Depreciation: Equipment equals 42,500. Total Assets are $80,875. Liabilities: Accounts Payable 5,500, Income Tax Payable 3,400, Unearned revenue 2,100. Total Liabilities 11,000. Stockholders’ Equity: Common Stock 70,000, Ending Retained Earnings (125), Total Stockholders’ equity 69,875. Total Liabilities and Stockholders’ equity 80,875.
Figure 5.25 Balance Sheet for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The balance sheet shows total assets of $80,875, which equals total liabilities and equity. Now that the financial statements are complete, Cliff will go to the next step in the accounting cycle, preparing and posting closing entries. To do this, Cliff needs his adjusted trial balance information.

Cliff will only close temporary accounts, which include revenues, expenses, income summary, and dividends. The first entry closes revenue accounts to income summary. To close revenues, Cliff will debit revenue accounts and credit income summary.

Journal entry for August 31, 2019 debiting Service Revenue 10,300, and Interest Revenue 350, and crediting Income Summary 10,650. Explanation: “To close revenue accounts to Income Summary.”

The second entry closes expense accounts to income summary. To close expenses, Cliff will credit expense accounts and debit income summary.

Journal entry for August 31, 2019 debiting Income Summary for 10,625 and crediting the following: Supplies Expense 50, Depreciation Expense: Equipment 2,500, Income Tax Expense 3,400, Salaries Expense 4,600, Utility Expense 75. Explanation: “To close expense accounts to Income Summary.”

The third entry closes income summary to retained earnings. To find the balance, take the difference between the income summary amount in the first and second entries (10,650 – 10,625). To close income summary, Cliff would debit Income Summary and credit Retained Earnings.

Journal entry for August 31, 2019 debiting Income Summary and crediting Retained Earnings each for 25. Explanation: “To close Income Summary to Retained Earnings.”

The fourth closing entry closes dividends to retained earnings. To close dividends, Cliff will credit Dividends, and debit Retained Earnings.

Journal entry for August 31, 2019 debiting Retained earnings and crediting Dividends each for 150. Explanation: “To close Dividends to Retained Earnings.”

Once all of the closing entries are journalized, Cliff will post this information to the ledger. The closed accounts with their final balances, as well as Retained Earnings, are presented in Figure 5.26.

T-Accounts. Dividends has an August 16 debit entry of 150, an August 31 credit closing entry of 150 and a debit balance of 0. Service Revenue account has 3 entries on the credit side: August 10 4,000, August 17 5,200, and August 31 of 1,100. It has a debit closing entry on August 31 of 10,300. The total on the credit side is then 0. Interest revenue has an August 31 credit entry of 350, an August 31 debit closing entry of 350, leaving a credit balance of 0. Salaries Expense has an August 22 debit side entry for 4,600, a credit side closing entry on August 31 for 4,600, and a debit side balance of 0. Utilities Expense has a August 13 debit side entry for 75, an August 31 closing credit entry of 75, and a debit side balance of 0. Supplies Expense has a debit entry on August 31 of 50, a closing credit entry of 50 on August 31, and a debit balance of 0. Depreciation Expense: Equipment has a debit entry on August 31 of 2,500, a credit side closing entry on August 31 for 2,500 and a debit balance of 0. Income Tax Expense has a debit entry on August 31 of 3,400, a closing credit entry of 3,400 on August 31, and a debit balance of 0. Income Summary has a credit closing entry #1, for 10,650, a debit closing entry #2 for 10,625, leaving a 25 credit balance, a debit closing entry #3 for 25, leaving an ending balance of 0. Retained Earnings has a credit closing entry #3 for 25, a debit closing entry #4 for 150, leaving a balance of 125.
Figure 5.26 Closed Accounts with Final Balances for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Now that the temporary accounts are closed, they are ready for accumulation in the next period.

The last step for the month of August is step 9, preparing the post-closing trial balance. The post-closing trial balance should only contain permanent account information. No temporary accounts should appear on this trial balance. Clip’em Cliff’s post-closing trial balance is presented in Figure 5.27.

Clip’em Cliff, Post-Closing Trial Balance, For the Month Ended August 31, 2019. Cash 35,275 debit. Accounts receivable 2,500 debit. Interest receivable 350 debit. Supplies 250 debit. Equipment 45,000 debit. Accumulated Depreciation: Equipment 2,500 credit. Accounts Payable 5,500 credit. Unearned Revenue 2,100 credit. Income Tax Payable 3,400 credit. Common Stock 70,000 credit. Retained Earnings 125 debit. Total debits and total credits are both 83,500.
Figure 5.27 Post-Closing Trial Balance for Clip’em Cliff. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

At this point, Cliff has completed the accounting cycle for August. He is now ready to begin the process again for September, and future periods.

Concepts In Practice

Reversing Entries

One step in the accounting cycle that we did not cover is reversing entries. Reversing entries can be made at the beginning of a new period to certain accruals. The company will reverse adjusting entries made in the prior period to the revenue and expense accruals.

It can be difficult to keep track of accruals from prior periods, as support documentation may not be readily available in current or future periods. This requires an accountant to remember when these accruals came from. By reversing these accruals, there is a reduced risk for counting revenues and expenses twice. The support documentation received in the current or future period for an accrual will be easier to match to prior revenues and expenses with the reversal.

Think It Through

Using Liquidity Ratios to Evaluate Financial Performance

You own a landscaping business that has just begun operations. You made several expensive equipment purchases in your first month to get your business started. These purchases very much reduced your cash-on-hand, and in turn your liquidity suffered in the following months with a low working capital and current ratio.

Your business is now in its eighth month of operation, and while you are starting to see a growth in sales, you are not seeing a significant change in your working capital or current ratio from the low numbers in your early months. What could you attribute to this stagnancy in liquidity? Is there anything you can do as a business owner to better these liquidity measurements? What will happen if you cannot change your liquidity or it gets worse?

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