Accounting: The Language of Business (Part 17)

“Each generation makes it’s own accounting to its children.” —Unknown

Completing the Accounting Cycle (Part A)

by

Charles Lamson 

Most of us have had to file a personal tax return. At the beginning of the year, you estimate your upcoming income and decide whether you need to increase your payroll tax withholdings or perhaps pay estimated taxes. During the year, you earn income, make investments, and enter into other tax-related transactions, such as making charitable contributions. At the end of the year, your employer sends you a tax withholding information form (W-2 form), and you collect the tax records needed for completing your yearly tax forms. If any tax is owed, you pay it; if you overpaid your taxes, you file for a refund. As the next year begins, you start the cycle all over again.

Businesses also go through a cycle of activities. At the beginning of the cycle, management plans where it wants the business to go and begins the necessary actions to achieve its operating goals. Throughout the cycle, which is normally 1 year, the accountant records the operating activities (transactions) of the business. At the end of the cycle, the accountant prepares financial statements that summarize the operating activities for the year. The accountant then prepares the accounts for recording the operating activities in the next cycle.

As we saw in part 7, the initial cycle for NetSolutions began with Chris Clark's investment in the business on November 1, 2022. The cycle continued with recording Netsolutions' transactions for November and December, as we discussed in the posts that followed. In the preceding posts, just prior to this one, the cycle continued and we recorded the adjusting entries for the two months ending December 31, 2022. In the next several posts, we discuss the flow of the adjustment data into the accounts and into the financial statements.

Accounting Cycle

The accounting process that begins with analyzing and journalizing transactions and ends with summarizing and reporting these transactions is called the accounting cycle. The most important output of this cycle is the financial statements.

In earlier posts, we described and illustrated the analysis and recording of transactions, posting to the ledger, preparing a trial balance, analyzing adjustment data, preparing adjusting entries, and preparing financial statements. In the next several posts, we complete our discussion of the accounting cycle by describing how work sheets may be used as an aid in preparing the financial statements. We also describe and illustrate how closing entries and a post-closing trial balance are used in preparing the accounting records for the next period.

Work Sheet

Accountants often use working papers for collecting and summarizing data they need for preparing various analyses and reports. Such working papers are useful tools, but they are not considered a part of the formal accounting records. This is in contrast to the chart of accounts, the journal, and the ledger, which are essential parts of the accounting system. Working papers are usually prepared by using a spreadsheet program on a computer.

The work sheet is a working paper that accountants can you use to summarize adjusting entries and the account balances for the financial statements. In small companies with few accounts and adjustments, a work sheet may not be necessary. In a computerized accounting system, a work sheet may not be necessary because the software program automatically posts entries to the accounts and prepares financial statements.

The work sheet (Exhibits 2 through 5) is a useful device for understanding the flow of the accounting data from the unadjusted trial balance to the financial statements (covered in the next post). This flow of data is the same in either a manual or a computerized accounting system.

Unadjusted Trial Balance Columns

To begin the work sheet, list at the top the name of the business, the type of working paper (work sheet), and the period of time, as shown in Exhibit 2. Next, enter the unadjusted trial balance directly on the work sheet. The work sheet in Exhibit 2 shows the unadjusted trial balance for NetSolutions at December 31, 2022.

EXHIBIT 2

Adjustments Columns

The adjustments that we explained and illustrated for NetSolutions in preceding posts are entered in the adjustments columns as shown in Exhibit 3. Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing the worksheet. It is also helpful for identifying the adjusting entries that need to be recorded in the journal.

EXHIBIT 3

The order in which the adjustments are entered on the worksheet is not important. Most accountants enter the adjustments in the order in which the data are assembled. If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should be inserted in the Account Title column, below the trial balance totals, as needed.

To review, the entries in the Adjustment columns of the worksheet are: 

1. Supplies. The supplies account has a debit balance of $2,000. The cost of the supplies on hand at the end of the period is $760. Therefore, the supplies expense for December is the difference between the two amounts, or $1,240. Enter the adjustment by writing (1) $1,240 in the Adjustments Debit column on the same line as Supplies Expense and (2) $1,240 in the Adjustments Credit column on the same line as Supplies.

2.  Prepaid Insurance. The prepaid insurance account has a debit balance of $2,400, which represents the prepayment insurance for 24 months beginning December 1. Thus, the insurance expense for December is $100 ($2,400/24). Enter the adjustment by writing (1) $100 in the Adjustments Debit column on the same line as Insurance Expense and (2) $100 in the Adjustments Credit column on the same line as Prepaid Insurance.

3. Unearned Rent. The unearned rent account has a credit balance of $360, which represents the receipt of 3 months' rent, beginning with December. Thus, the rent revenue for December is $120. Enter the adjustment by writing (1) $120 in the Adjustments Debit column on the same line as Unearned Rent and (2) $120 is in the Adjustments Credit column on the same line as Rent Revenue.

4.  Wages. Wages accrued but not paid at the end of December total $250. This amount is an increase in expenses and an increase in liabilities. Enter the adjustment by writing (1) $250 in the Adjustments Debit column on the same line as Wages Expense and (2) $250 in the Adjustments Credit column on the same line as Wages Payable.

5.  Accrued Fees. Fees accrued at the end of December but not recorded total $500. This amount is an increase in an asset and an increase in revenue. Enter the adjustment by writing (1) $500 in the Adjustments Debit column on the same line as Accounts Receivable and (2) $500 in the Adjustments Credit column on the same line as Fees Earned.

6.  Depreciation. Depreciation of the office equipment is $50 for December. enter the adjustment by writing (1) $50 in the Adjustments Debit column on the same line as Depreciation Expense and (2) $50 in the Adjustments Credit column on the same line as Accumulated Depreciation.

Total the Adjustments columns to verify the mathematical accuracy of the adjustment data. The total of the debit column must equal the total of the credit column. 

Adjusted Trial Balance Columns

The adjustment data are added to or subtracted from the amounts in the unadjusted Trial Balance columns. The adjusted amounts are then extended to (placed in) the Adjusted Trial Balance columns, as shown in Exhibit 3. For example, the cash amount of $2,065 is extended to the Adjusted Trial Balance Debit column, since no adjustments affected Cash. Accounts Receivable has an initial balance of $2,220 and a debit adjustment (increase) of $500. The amount to write in the Adjusted Trial Balance Debit column is the debit balance of $2,720. The same procedure continues until all account balances are extended to the Adjusted Trial Balance columns. Total the columns of the Adjusted Trial Balance to verify the equality of debits and credits.

Income Statement and Balance Sheet Columns

The work sheet is completed by extending the adjusted trial balance amounts to the Income Statement and Balance Sheet columns. The amounts for revenues and expenses are extended to the Income Statement columns. The amounts for assets, liabilities, owner's capital, and drawing are extended to the Balance Sheet columns.

In the NetSolutions' work sheet, the first account listed is Cash, and the balance appearing in the Adjusted Trial Balance Debit columns is $2,065. Cash is an asset, is listed on the balance sheet, and has a debit balance. Therefore, $2,065 is extended to the Balance Sheet Debit column. The Fees Earned balance of $16,840 is extended to the Income Statement Credit column. The same procedure continues until all account balances have been extended to the proper columns, as shown in Exhibit 4.

EXHIBIT 4

After all of the balances have been extended to the four statement columns, total each of these columns, as shown in Exhibit 5. The difference between the two Income Statement column totals is the amount of the net income or the net loss for the period. Likewise, the difference between the two Balance Sheet column totals is also the amount of the net income or net loss for the period.

EXHIBIT 5

If the Income Statement Credit column total (representing total revenue) is greater than the income statement debit column total (representing total expenses), the difference is the net income. If the income statement debit column total is greater than the income statement credit column total, the difference is a net loss. For NetSolutions, the computation of net income is as follows:

As shown in Exhibit 5, write the amount of the net income, $7,205, in the Income Statement Debit column and the Balance Sheet column. Write the term Net income in the account title column. If there was a net loss instead of net income, you would write the amount in the Income Statement Credit column and the Balance Sheet Debit column and the term Net loss in the Account Title column. Inserting the net income or net loss in the statement columns on the work sheet shows the effect of transferring the net balance of the revenue and expense accounts to the owner's capital account. In a later post, we explain how to journalize this transfer.

After the net income or net loss has been entered on the worksheet, again total each of the four statement columns. The totals of the two Income Statement columns must now be equal. The totals of the two Balance Sheet columns must also be equal. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 140-143*

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