Accounting: The Language of Business - Vol. 2 (Intermediate: Part 24)

It's really amazing that in the age of unbelief, as a smart man called it, there isn't even more fraud. After all, with no God, there's no one to ever call you to account, and no accounting at all if you can get away with it.

Ben Stein

Review of the Accounting Cycle (Part A)

by

Charles Lamson

Introduction

Companies sell merchandise, purchase inventory, and compensate employees everyday---and each individual event represents a transaction. Consider the retailer Target. In its 1,792 U.S. stores, it reported sales of over $73 billion and employed over 390,000 people in fiscal year 2015 (Gordon, Raedy, Sannella, 2019). These statistics indicate the magnitude of Target's transactions. For example, if Target paid each employee weekly, there would be over 20 million paychecks issued in a year.

A company's accounting system tracks all the transactions that occur every day and ultimately aggregates and summarizes them in publicly available financial statements. The accounting cycle describes the process by which a company records transactions in its books and summarizes their effects in the financial statements.

In the next several posts, we discuss the nine steps in the accounting cycle. The process starts with the transaction analysis to determine whether an economic event has occurred that changes assets, liabilities, or stockholders' equity [the assets remaining in a business once all liabilities have been settled (Investopedia)]. After making this determination, a company journalizes transactions and posts them to its ledger accounts. Next, the entity ensures numerical accuracy of the process by preparing a trial balance. Before preparing financial statements, a company determines whether adjustments are required to ensure that it has reported all economic events occurring in that period. Finally, it prepares the financial statements and closes all temporary accounts. Temporary accounts are short-term accounts that start each accounting period with zero balance and close at the end to maintain a record of accounting activity during that period. They include the income statements, expense accounts, and income summary accounts (thebalancemoney.com).

These steps ensure that every transaction flows to the financial statements, enabling investors, creditors, and other financial statement users to use the statements to analyze a company's financial position and economic performance. 

The Accounting Cycle

The accounting cycle describes the process by which a company records business transactions and ultimately aggregates and summarizes them in the financial statements. As a roadmap for the next several posts, Exhibit 4.1 presents the nine steps in the accounting cycle. The accounting cycle steps do not depend on the accounting standards being used: whether a company uses GAAP or IFRS, the accounting cycle begins with analyzing transactions and ends with a post-closing trial balance. 

EXHIBIT 4.1 The Accounting Cycle

Step 1: Analyze the Transaction

A transaction is an economic event that involves a change in an asset, a liability, or a stockholders' equity account that companies record in their accounting records. The accounting equation (also called the balance sheet equation) is initially used to analyze transactions. We begin this section by reviewing the accounting equation and then expand it to illustrate transaction analysis.

The Accounting Equation

The accounting equation illustrates the relationship among assets, liabilities, and stockholders' equity as follows:

(4.1a)

Assets = Liabilities + Stockholders' Equity

Or, using abbreviations, this equation is:

(4.1b)

A = L + E

The accounting equation demonstrates that creditors and owners have claims to a company's assets. We review the definition of each element of the accounting equation in Exhibit 4.2 along with examples of each element.

EXHIBIT 4.2 Accounting Equation Definitions (U.S. GAAP definitions from FASB Concepts Statement Number 6, Elements of Financial Statements. IFRS definitions are nearly identical.) 

The fact that all transactions affect at least two accounts and that the accounting equation will always balance is referred to as the double-entry system. For example, if an asset increases, then there must be either a decrease in another asset, an increase in liabilities, or an increase in stockholders' equity.

An expanded version of the accounting equation includes the various components of stockholders' equity. Stockholders' equity in equation form is:

(4.2)

Stockholders' Equity = Contributed Capital + Ending Retained Earnings + Accumulated Other Comprehensive Income

Contributed capital consists primarily of owners' investments in the business. Accumulated other comprehensive income increases or decreases with other comprehensive income. Other comprehensive income is an additional component of comprehensive income. We introduce other comprehensive income and accumulated other comprehensive income now, due to its complexity, and we explore in much more detail in future posts.

Revenue and gains increase retained earnings, whereas expenses, losses, and distributions to owners (dividends) decrease retained earnings. We represent retained earnings in equation form as follows:

(4.3)

Ending Retained Earnings = Beginning Retained Earnings + Revenues + Gains - Expenses - Losses - Dividends Declared

When revenues and gains exceed expenses, losses, and dividends over time, retained earnings is positive. Retained earnings is negative when expenses, losses, and dividends exceed revenues and gains over time. A negative balance in retained earnings is called a deficit. We review definitions of each of these terms in Exhibit 4.3. 

EXHIBIT 4.3 Expanded Accounting Equation Elements (U.S. GAAP definitions from FASB Concepts Statements No. 6. Elements of Financial Statements. IFRS definitions are somewhat different, but these differences do not affect the explanations of the steps in the accounting cycle.)

Exhibit 4.4 presents the components of stockholders' equity graphically. Consistent with Equation 4.2, stockholders' equity is comprised of contributed capital, ending retained earnings, and accumulated other comprehensive income. Also, ending retained earnings is equal to beginning retained earnings and is increased by net income and decreased by net losses and dividends. Net income (and net loss) is increased by revenues and gains and decreased by expenses and losses.

EXHIBIT 4.4 Components of Stockholders' Equity

Given Equations 4.2 and 4.3, we expand the basic accounting equation to represent the elements of stockholders' equity as follows:

This expanded equation allows companies to analyze complex transactions, which will be illustrated in an example in the next post. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ALGEBRA, 2ND ED., PP. 91-95*

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