Accounting Cycle and Financial Statements

• Chapter 4 covers completing the accounting cycle

Key Objectives

• Prepare financial statements with a classified balance sheet
• Prepare the post-closing trial balance
• Describe the accounting cycle

The Accounting Cycle

• It includes identifying and analyzing transactions
• Record journal entries
• Post to the general ledger
• Prepare the unadjusted trial balance
• Make adjusting entries
• Prepare the adjusted trial balance
• Prepare financial statements
• Make closing entries

Accounting Equation

• The basic accounting equation is Assets = Liabilities + Equity
• Assets = Liabilities + (Common Stock + Retained Earnings)
• Historical revenue, expenses, and dividends impact the equation
• Resource of business with future benefit is an Asset
• Something owed by business is a Liability
• Equity is the net worth of a business
• Increased Equity revenue and common stock
• Decreased Equity by expenses and dividends
• Common Stock represents ownership in the company

Understanding Expenses and Revenue

• Retained Earnings = Historical revenue less historical expenses and dividends
• Revenue is resources earned that must come from:
  • Earned fees
  • Provided services
  • Sold goods
• Expenses is the cost of operation used to generate revenue
• A dividend is the distribution of company earnings to shareholders
• Net Income = Current year revenue less current year expenses

Debits & Credits

• An Asset's debit increases and a credit decreases
• A Liability's debit decreases and a credit increases
• Equity's debit decreases and a credit increases
• Expense and dividend accounts are always debited
• Revenue and common stock accounts are always credited

Learning Objective 4.1

• Prepare financial statements, including the classified balance sheet

Financial Statements

• The income statement reports revenues and expenses
• It calculates net income or net loss for the period which determines profitability
• The statement of retained earnings shows how retained earnings changed
• This is due to net income (or net loss) and dividends
• The balance sheet reports assets, liabilities, and stockholders' equity
• This is as of the last day of the period

Financial Statement Connections

• A sample SMART TOUCH LEARNING income statement for two months ending December 31, 2024, lists Service Revenue at $17,500
• The expenses are Salaries Expense at $4,800, Rent Expense at $3,000, Supplies Expense at $400 and others
• It comes to a total expense of $8,950 resulting in a Net Income of $8,550
• Beginning Retained Earnings was $0
• Net income added $8,550, then Dividends subtracted ($5,000)
• The result is the Retained Earnings on December 31, 2024, at $3,550
• The Balance Sheet lists Assets like Cash at $12,200, Accounts Receivable at $1,800, etc
• Liabilities include Accounts Payable at $200, Utilities Payable at $100 and more
• Total Assets balance with Total Liabilities and Stockholders' Equity

Financial Statement Relationships

• Net Income increases Retained Earnings, while Dividends decrease it
• Beg RE + Net Income - Dividends = Ending RE

Classified Balance Sheet

• It places each asset and liability into a specific category
• Assets are shown in order of liquidity
• Liabilities are current if due within one year
• Liabilities are long term if due after one year
• Liquidity measures how quickly and easily an account can be converted to cash

Assets

• Current assets are converted to cash, sold, or used up within the next 12 months
• This also applies within the business's operating cycle if it's longer than a year
• Cash is the most liquid asset and is used to acquire goods and services
• Other current assets include:
  • Accounts receivable
  • Inventory
  • Supplies
  • Short term investments
• Long-term assets will not be converted to cash or used up within the business's operating cycle

Long term Assets

• Long-term investments are investments in bonds or stocks
• The company intends to hold for longer than one year
• Property, Plant, and Equipment are long-lived, tangible assets
• Property, plant, and equipment are used in the operation of a business
• Intangible Assets are assets with no physical form. Examples include:
  • Patents
  • Copyrights

Liabilities

• Current liabilities must be paid either with cash or with goods and services:
  • Accounts Payable
  • Salaries Payable
  • Unearned Revenue
• Long-term liabilities do not need to be paid within one year or within the operating cycle
• A note payable greater than 1 year; a loan payable greater than 1 year

Stockholder's Equity

• Stockholders' equity represents the stockholders' claims to the assets of the business
• This includes through common stock (Common Stock Account)
• Plus the amount of historical net income not yet paid to investors
• Key: Equity = Assets – Liabilities
• Or, the residual value of business if company sales all assets
• After using the cash to pay off all liabilities, Equity is what is left

Learning Objective 4.3

• The goal is to bring Revenue, Expense and Dividend accounts to zero to start the new year

Closing Process

• It zeroes out all revenue, expense, and dividends accounts which are also known as temporary accounts
• Temporary accounts are closed to retained earnings at the end of a period
• Permanent accounts are not closed at the end of the period
• Balance sheet accounts like asset, liability, common stock, and retained earnings accounts
• Closing entries transfer revenues, expenses, and Dividends to Retained Earnings
• Revenues and expenses are transferred first to an account titled Income Summary
• Income Summary is a temporary account that summarizes the net income (or net loss) for the period
• The formula for Ending Retained Earnings is Beg RE + Net Income - Dividends

Learning Objective 4.4

• Prepare the post-closing trial balance

Post-Closing Trial Balance

• The accounting cycle ends with a post-closing trial balance
• It lists the accounts and their balances at the end of the period
• This is after journalizing and posting the closing entries
• Includes only permanent accounts (Balance Sheet)
• Revenue, Expense and Dividends accounts are zero to start a the year

Learning Objective 4.5

• Describe the accounting cycle

Accounting Cycle

• It is the process by which companies produce their financial statements for a specific period
• Represents the steps that are followed throughout the time period
• It starts with the beginning asset, liability, and stockholders' equity account balances
• The account balances are left over from the preceding period
• After year 1, balance sheet accounts have a beginning balance which is the prior year ending balance
• Income statement accounts start at 0