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welcome to they tell me what I need to know series this unit is designed to help solidify your understanding of the accounting cycle as is the case with any challenging material it's always a good idea to try to understand the big picture before delving into the details the first thing to understand about the accounting cycle steps that you see here on this slide is that they are leftovers from the days when accounting systems were completely manual systems as is typical in any manual system an element of human error is present in manual accounting information systems and does an attempt to minimize this error several helpful procedures are woven into the process one of these procedures is the use of a tool called the trial balance and we'll look at how it works shortly nowadays accounting software has made many of the steps you see here automatic or redundant if you use Peachtree or QuickBooks for example the interface you see will obscure the accounting cycle I'm about to describe so why do we still study the accounting cycle in today's accounting classes while studying these steps is a way to establish a solid understanding of how accounting information in the form of source documents like invoices checks purchase orders etc ultimately impact the financial statements of a company a clear understanding of the accounting cycle also helps us to be aware of how our actions impact what ultimately gets presented in the form of financial statements the objective of the accounting cycle is to produce financial statements predominantly for external users these statements are the balance sheet income statement statement of cash flows and if shown separately the statement of changes in owner's equity here are some important terms that you need to know before we proceed any further an account is simply a record or list of activity for each element of the financial statements that were interested in examples include cash accounts receivable accounts payable inventory equipment patents sales revenue and retained earnings because of the nature of the accounting cycle it's possible theoretically at least to check the result of activity to date in most of the accounts a journal is a book of accounting events kept in chronological order and in manual accounting information systems journals are physical books this is where business owners note each transaction as it occurs transaction information contained in the journal is later transferred to the individual accounts today most journal entries are made electronically using keyboards scanners and other methods of recognition this is because nowadays most accounting information systems are computerized as a result journals only exist in virtual form in these systems though they can easily be printed on hardcopy if required businesses always have one general journal and they may also keep a number of special journals more about this on the next slide a ledger is a compilation of accounts used by businesses and immanuel accounting information systems is also a physical book the general ledger is a compilation of general ledger accounts and the subsidiary ledgers are compilations of the subsidiary ledger accounts we'll talk a little more about this shortly nowadays in computerized systems Ledger's also only exist in virtual format journals are often referred to as the books of original entry because in manual systems that's where business events are first entered into the counting information system at convenient intervals the transaction information from the journals is transferred to the accounts in a process known as posting large businesses may keep more than one journal so that they can group similar transactions together in separate journals an example of this arrangement is devoting one journal to cash receipts and using the general journal for everything else not surprisingly these separate journals are called special journals special journals are useful because instead of transferring transactions wanted to time to the ledgers we can transfer daily transaction totals at the end of every day for example thus at the end of the day we might post the day's cash sales total to the sales revenue general ledger account instead of posting each sale individually this saves quite a lot of time in manual accounting information systems this journal entry records the receipt of cash by a business in exchange for goods or services that it will deliver in the future and is a common event for magazine publishers when customers pay in advance for magazines the business records the cash it has received by debiting cash and the corresponding credit is to a liability account called unearned revenue depending on the nature of the good or service that will be delivered the credit will be to honor and sales revenue on an service revenue or something like that this journal entry records the payment of wages or salaries to employees this journal entry records a credit sale of goods in a perpetual inventory system the first part of the journal entry records the sale of the goods and is recorded at the sale price of the goods since the sailors on credit the business does not receive cash from the customer but instead receives a promise to pay or IOU we call these IOUs accounts receivable and they are assets of the business by debiting this asset accounts receivable we record that accounts receivable have increased the corresponding credit is to sales revenue to record the revenue from the sale in a periodic inventory system this would be the only journal entry made at the time of the sale inventory would be adjusted at the end of the accounting cycle in a perpetual inventory system the second part of the journal entry is necessary to keep our inventory accounts perpetually up to date the debit to cost of goods sold records the merchandise expense associated with the sale at the cost of the goods to the seller the credit to inventory records the fact that the business now owns less inventory than it did before because it has just sold some this final example journal entry illustrates the credit purchase of merchandise inventory for resale by a business the debit to inventory records that inventory has increased and is necessary in a perpetual inventory system to keep the inventory accounts perpetually up to date the corresponding credit is to an IOU account this time showing that the business owes money to its supplier for this purchase I owe use owed by businesses are called accounts payable and accounts payable are liabilities of the business if this had been a periodic inventory system the debit would have been made to an account called purchases instead as mentioned earlier manual accounting information systems usually have two types of ledger accounts general ledger control accounts kept in the general ledger and subsidiary ledger accounts kept in the subsidiary ledgers the general ledger control account balances equal the totals of their corresponding subsidiary account balances for example businesses need to keep track of how much they are owed by each of their credit customers when a business records a journal entry reflecting a payment from a customer towards the customers account balance the business needs to post it to that specific customers account similarly when a customer makes a purchase on credit it is important to post the information to that specific customers account these customer accounts are called subsidiary ledger accounts the general ledger accounts receivable control account is simply the sum of the individual customers subsidiary ledger accounts similar arrangements exist for accounts payable the amounts we owe to our creditors inventory are assets held for resale and any other account where it is operationally necessary to keep a separate record of the details within a general ledger control account posting is the process of transferring details of transactions from the journal or journals to the ledger accounts we post to subsidiary ledgers for example accounts receivable and accounts payable one transaction at a time to preserve the details of our credit customers activities and our purchases and payments to our creditors we post totals on the other hand from the special journals to the general ledger because we don't need to preserve the individual details for example we can post our total sales on credit to our general ledger sales revenue account and total cash receipts from sales to our general ledger sales revenue account these two postings are much quicker than posting each sale transaction separately because we are effectively not posting both sides of each journal entry at precisely the same time there may be temporary imbalances between debits and credits this is just a procedural phenomenon though and once we have finished posting our debits should once again equal our credits and our subsidiary ledger balances will equal our general ledger balances posting of course occurs automatically in computerized accounting information systems first a note about double entry accounting double entry accounting simply means that each journal entry affects at least two accounts this slide shows two journal entries first notice that debits are grouped together first and indented to the left second notice that credits are grouped together last and are indented to the right use this form in all of your accounting classes as it makes the journal entries easier to recognize and read in the first case we have a credit to cash showing a cash outlay and the second part of the journal entry shows is what the outlay was for in this case the director inventory tells us that the cash outlay was made to purchase inventory in the second case we have the same debit to inventory showing its purchase but this time we have credits to cash and accounts payable this tells us that part of our purchase was made with cash and part on credit by using the double entry format we guard against forgetting to record part of the transaction since our debit entries must always equal our credit entries even at the individual journal entry stage it's quite easy to see if we have omitted any important facts trial balances are tools used in manual accounting information systems to help us periodically verify that the total of our debit entries to our accounts equals the total of our credit entries by listing our debit account balances in a column to the left and our credit account balances in a column to the right and totaling each column it's relatively easy to check that they are equal or should I say they balance this evidence tells us important but limited information it tells us that debits equal credits and no more if we have posted to the wrong account as long as we correctly posted as a debit or credit a trial balance will not expose this mistake similarly if we omit to post a transaction completely our debits and credits will still balance and a trial balance will not expose this mistake either trial balances are redundant operational steps nowadays in computerized accounting systems usually because computerized accounting packages are designed to prevent our transactions from being out of balance nevertheless trial balances are still an important teaching tool because they help to reinforce the notion of debit and credit equality trial balances only exist in virtual forming computerized accounting systems but they can easily be printed out or displayed on a screen which can be useful for examining account balances at a particular point in time because generally accepted accounting principles or GAAP requires us to use accrual accounting the need to make adjusting journal entries arises you may recall that accrual accounting means that we recognize revenues when realized or realizable and earned and we match expenses to the revenues that they help to produce sometimes though we receive cash before performing our revenue earning activities and sometimes we receive it afterwards similarly we sometimes pay expenses in advance and sometimes we incur expenses before we pay for them in accounting terms this means that we sometimes accrue revenues and expenses and sometimes experience deferred revenues and expenses a simple way to memorize the meaning of accruals and deferrals is that accrual events involve action first and dollars later whereas deferral events involve dollars first and action later it is these accrual and deferral events that cause the need for adjusting journal entries this slide shows some ways in which accrued revenues occur notice that all these examples illustrate situations in which the revenue earning process is complete but the cash is not yet received it's quite possible that these revenue items will remain unrecorded during the accounting period because no event occurs to prompt the recording so if we don't make adjusting journal entries they'll be excluded from the financial statements using double entry accounting the journal entry to record each of these revenue earning events will involve a debit to a receivable or IOU from our customer and a credit to a revenue account here's how we make the adjusting journal entries for the three previous examples notice that in each case we debit a receivable account and credit a corresponding revenue account failure to make these adjustments at the end of the accounting period would result in an understatement of revenues net income retained earnings and equity and an understatement of assets namely receivables here are some ways in which expenses can be accrued notice that in all these cases expenses are incurred that should be matched with current revenue again it is likely that no expense has been recorded during the accounting cycle for these events so we will need to make adjusting journal entries instead here's how we make the adjusting journal entries to record the accrued expenses for the three previous examples notice that in each case we debit an expense and credit a corresponding payable to show that we opened for these items if we omit to make this adjustment our expenses and liabilities will be understated and our net income retained earnings and equity will be overstated here are some ways in which businesses might receive cash that they have not yet earned recall that using accrual accounting the revenue recognition principle dis allows us from recording revenue until it is earned since there has been a cash receipt this must be recorded the corresponding credit is to a liability that shows an obligation to provide goods or services in the future when some or all of this revenue becomes earned an adjusting journal entry will be made to reflect that fact this first journal entry shows the receipt of cash for future delivery of goods or services this is not an adjusting entry but is recorded at the time of the cash receipt the second journal entry shows the adjusting entry to recognize that some or all of the revenue has become earned notice that the adjusting entry serves to transfer amounts from the unearned revenue account to the earned revenue account if we omit this adjusting entry liabilities will be overstated and revenue net income retained earnings and equity will be understated here are some examples of how businesses might pay in advance for future expense items recall that under accrual accounting the matching principle requires that we match expenses to the revenues that they helped to produce instead of just recording them currently this slide shows that as soon as we have made a cash outlay for a future expense item we record the payment at that time with a credit to cash the corresponding debit is made to a prepaid expense account which is an asset account this entry is not an adjusting journal entry but is simply made at the time at which we make the cash outlay as the asset becomes used up or expires it is important that we make an adjusting journal entry to show the reduction in the balance of the prepaid expense and that some expense has now been incurred if we fail to make this adjusting journal entry assets net income retained earnings and equity will be overstated and expenses will be understated the purchase of productive assets such as factories machines and business vehicles is also a type of prepaid expense in that the purchase occurs first followed by a systematic and rational allocation of the cost in to expense over time the name for this expense is depreciation expense one overwhelming matter of importance on this topic is that the objective of the depreciation process is to match the cost of these productive assets to the revenue that they helped to generate our systematic and rational method of cost allocation will reflect the fact that different productive assets have different useful lives and that they contribute to revenue production in different patterns over time let's look at an example of a fixed asset purchase and subsequent allocation of its cost into expense using the process of depreciation in this first journal entry a fixed asset is purchased for $1,100 cash the asset is expected to have a useful life of four years and an estimated salvage value of $100 at the end of four years the second journal entry shows the annual adjusting journal entry to record depreciation expense of two hundred and fifty dollars the calculations are shown on the next slide to calculate one full year of depreciation expense on this asset we deduct the estimated salvage value from the historical cost of the asset and divide by the expected number of years useful life salvage value is our estimate of the amount that we could exchange the asset for when we're finished with it the expected useful life is our estimate of the time period during which we anticipate that the asset will help us to generate revenue satisfactorily as you can see the calculated depreciation expense is two hundred and fifty dollars for each full year this method of calculating depreciation expense is called the straight-line method and allocates the cost of the asset into expense evenly over time much of the time productive assets are not put into use on the first day of the accounting year so the first and last year's of the assets life will show partial year amounts for example if this asset were placed into service on June 30th only 125 dollars of depreciation expense would be recorded on this financial statements for the first calendar year of its use for years two through four the expense will be two hundred and fifty dollars each year and for the fifth year the expense will once again be a hundred and twenty five dollars the purchase of supplies used in our business is also a prepaid expense examples of supplies include paper clips paper toner pens pencils staples and other items that will be used up incidentally to our business activity in the real world these items may be a material in cost so the actual treatment may be different to what I'm about to describe here nevertheless when studying accounting it's always preferable to learn the theoretically correct treatment when we purchase supply items for the business we debit an account called supplies at cost this is an asset account in the case of a cash purchase the corresponding credit is made to cash you may also hear the supplies account referred to as supplies inventory which is perfectly correct but don't get it confused with merchandise inventory for sale in the normal course of business as we use up the supplies we need to be sure to debit supplies expense an expense account and credit supplies the asset account to reflect the fact that our stock of supplies has declined this is usually done as an adjusting journal entry at the end of the accounting period and simultaneously records the supplies expense should we fail to make this adjusting entry expenses will be understated and assets net income retained earnings and equity will be overstated be sure to note the difference between these similar-sounding accounts supplies or supplies inventory is the asset account which measures the quantity of supplies on hand supplies expense is the expense account which measures the quantity of supplies consumed during the accounting period recall that trial balances are tools used in manual accounting information systems to help us to periodically verify that our cumulative debit entries to our accounts equals our cumulative credit entries by physically listening our debit account balances and our credit account balances and finding their respective totals it is relatively easy to check that they are equal or should I say they balance while we may list trial balances at any point during the manual accounting process to check on our progress it is also typical in a manual accounting information system to perform a trial balance after making our final adjusting journal entry of the accounting period this trial balance is called an adjusted trial balance adjusted trial balances have the same limitations that we discussed earlier relating to trial balances in manual accounting information systems we use the account totals on our adjusted trial balance to construct our financial statements it is typical to start by building the income statement using the revenue expense gain and loss accounts having calculated net income it is possible to construct a statement of changes in owner's equity we take the beginning balance in owner's equity from last periods balance sheet or statement of changes in owner's equity the balance sheet is prepared from the permanent accounts on the adjusted trial balance finally the statement of cash flows is prepared from the cash balance on the adjusted trial balance this is the ending balance we take the beginning balance from last periods balance sheet or statement of cash flows we also need detailed information about the type of cash flows that occurred notice that the ending cash balance on our balance sheet and statement of cash flows must be the same because they both measure the same thing at the end of the accounting cycle we like to empty our temporary account so that we can start counting at zero again in the following year some accounting texts will show you how to close these balances into an account called income summary and this method is illustrated here the end of period balances in the revenues accounts will show credit balances so these accounts must be debited to close them out this is shown in the first journal entry and results in an increase in the income summary account the end of period balances in the expenses account will show debit balances so these accounts must be credited to close them out this is shown in the second journal entry and results in a decrease in the income summary account notice that after we've made our closing entries into the income summary account its balance will equal our net income for the year subsequently the income summary account is closed into retained earnings this increases retained earnings if the company has made a profit and this is shown in the third journal entry finally the debit balance in the dividends declared account is credited and the corresponding debit is made to retained earnings this reduces retained earnings by the amount of dividends declared during the accounting period other accounting texts will show you how to close these balances directly into the retained earnings account and this method is illustrated here both methods are equally correct and nowadays reflect nothing more than different teaching methods since most accounting systems in use today are computerized a post-closing trial balance is a trial balance performed after the closing journal entries have been made consequently balances will only appear in the permanent accounts this is because the temporary accounts have been emptied in the closing process that completes the activities in the accounting cycle now we start the whole process over for the next accounting period