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8/8/2019 00 - Accounting Concepts Training Manual

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INTRODUCTION TO FINANCIAL ACCOUNTING

PREPARED BY INFORMATION MANAGEMENT SYSTEMS

Financial Accounting ........................................................................................................................... 2Introduction ...................................................................................................................................... 2Accounting Standards ...................................................................................................................... 2

Financial Statements ............................................................................................................................ 2Transactions ......................................................................................................................................... 3

The Accounting Process................................................................................................................... 3

Accounting Concepts ........................................................................................................................... 4Underlying Assumptions and Principles .......................................................................................... 4Assumptions ..................................................................................................................................... 4Principles .......................................................................................................................................... 4

Single Entry Bookkeeping ................................................................................................................... 4Single Column System ..................................................................................................................... 5Separating Revenues and Expenses ................................................................................................. 5

Double Entry Bookkeeping .................................................................................................................. 6The Accounting Equation .................................................................................................................... 7Debits and Credits ................................................................................................................................ 9The Accounting Cycle ......................................................................................................................... 9The Source Document ........................................................................................................................ 11

Journal Entries.................................................................................................................................... 12Format of a General Journal Entry ................................................................................................. 12Compound Journal Entries ............................................................................................................. 12Format of a Compound General Journal Entry .............................................................................. 12Special Journals.............................................................................................................................. 13From Journal Entry to Ledger Posting ........................................................................................... 13

The General Ledger ........................................................................................................................... 13General Journal Entry .................................................................................................................... 13Ledger Accounts ............................................................................................................................ 14Debits and Credits .......................................................................................................................... 14

Trial Balance ...................................................................................................................................... 28Adjusting Entries................................................................................................................................ 29

Accruals ................................................................................................................................. 30 Deferrals ................................................................................................................................. 30

How to Make Adjusting Entries......................................................................................................... 30Accrued Items ................................................................................................................................ 30

Adjusting Entry for Interest Accrual .......................................................................................... 30Journal Entry for Interest Received ........................................................................................... 30

Deferred Items................................................................................................................................ 30Journal Entry for Prepaid Insurance........................................................................................... 31Adjusting Entry for Prepaid Insurance....................................................................................... 31

Closing Entries ............................................................................................................................... 311. Close Revenue to Income Summary ..................................................................................... 32

2. Close Expenses to Income Summary .................................................................................... 323. Close Income Summary to Retained Earnings ..................................................................... 324. Close Dividends to Retained Earnings.................................................................................. 33

Posting of the Closing Entries ........................................................................................................ 33Post-Closing Trial Balance ............................................................................................................ 33

The Four Financial Statements .......................................................................................................... 33Balance Sheet ................................................................................................................................. 34Income Statement ........................................................................................................................... 34Statement of Owners' Equity ......................................................................................................... 35Cash Flow Statement ..................................................................................................................... 35


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Financial Accounting

Introduction

The purpose of accounting is to provide the information that is needed for sound economicdecision making. The main purpose of financial accounting is to prepare financial reports

that provide information about a Organizations performance to external parties such asinvestors, creditors, and tax authorities. Managerial accounting contrasts with financialaccounting in that managerial accounting is for internal decision making and does not haveto follow any rules issued by standard-setting bodies. Financial accounting, the other hand,is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.

Accounting Standards

In order that financial statements report financial performance fairly and consistently, theyare prepared according to widely accepted accounting standards. These standards arereferred to as Generally Accepted Accounting Principles, or simply GAAP. Generally

Accepted Accounting Principles are those that have "substantial authoritative support".

Accrual vs. Cash Method

Many public and private agencies utilize an accounting system that recognizes revenueand expenses on a cash basis, meaning that neither revenue nor expenses arerecognized until the cash associated with them actually is received or paid.

However large businesses and public institutions use the accrual method.

Under the accrual method, revenues and expenses are recorded according to when theyare earned and incurred, not necessarily when the cash is received or paid. For example,

under the accrual method revenue is recognized when customers are invoiced, regardlessof when payment is received. Similarly, an expense is recognized when the bill is received,not when payment is made.

Under accrual accounting, even though employees may be paid in the next accountingperiod for work performed near the end of the present accounting period, the expense stillis recorded in the current period since the current period is when the expense wasincurred.

Financial Statements

Businesses and public institutions have two primary objectives:

Provide services Being accountable Earn a profit Remain solvent

Solvency represents the ability of the business to pay its bills and service its debt.


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The four financial statements are reports that allow interested parties to evaluate theprofitability, accountability and solvency of a public/private agency. These reports includethe following financial statements:

Balance Sheet Income Statement

Statement of Owner's Equity (only for business) Statement of Cash Flows

These four financial statements are the final product of the accountant's analysis of thetransactions of an agency. A large amount of effort goes into the preparation of thefinancial statements. The process begins with book-keeping, which is just one step in theaccounting process. Book-keeping is the actual recording of the agency's transactions,without any analysis of the information. Accountants evaluate and analyze the information,making sense out of the numbers.

For the reports to be useful, they must be:

Understandable Timely Relevant Fair and Objective (free from bias)

Transactions

To record transactions, one must:

1. Identify an event that affects the entity financially.2. Measure the event in monetary terms.

3. Determine which accounts the transaction affects.4. Determine whether the transaction increases or decreases the balances in thoseaccounts.

5. Record the transaction in the ledgers.

Under double entry, instead of recording a transaction in only a single account, thetransaction is recorded in two accounts.

The Accounting Process

Once a financial transaction occurs, a sequence of activities begins to identify and analyzethe transaction, make the journal entries, etc. Because this process repeats over

transactions and accounting periods, it is referred to as the accounting cycle.


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Accounting Concepts

Underlying Assumptions and Principles

Financial accounting relies on several underlying concepts that have a significant impacton the practice of accounting.

Assumptions

The following are basic financial accounting assumptions:

Separate entity assumption - the business/agency is an entity that is separate anddistinct from its owners, so that the finances of the firm are not co-mingled with thefinances of the owners.

Going concern assumption - the business/agency is going to be operating for theforeseeable future.

Stable monetary unit assumption - e.g. the U.S. dollar Fixed time period assumption - info prepared and reported periodically (quarterly,

annually, etc.)

Principles

The basic assumptions of accounting result in the following accounting principles:

Historical cost principle - assets are reported and presented at their original costand no adjustment is made for changes in market value. One never writes up thecost of an asset. Accountants are very conservative in this sense. Sometimes costsare written down, for example, for some short-term investments and marketablesecurities, but costs never are written up.

Matching principle - matching of revenues and expenses in the period earned andincurred.

Revenue recognition principle - revenue is realized (reported on the books asearned) when everything that is necessary to earn the revenue has beencompleted.

Full disclosure principle - all of the information about the business entity that isneeded by users is disclosed in understandable form.

Single Entry Book-keeping

Most of financial accounting is based on double-entry book-keeping. To understand andappreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry book-keeping system. In its most basic form, a single-entry system is similar to acheckbook register and is characterized by the fact that there is only a single line enteredin the journal for each transaction. In a simple checkbook, each transaction is recorded inone column of an account as either a positive or a negative amount in order to representthe receipt or disbursement of cash. This system is demonstrated in the following examplefor a repair shop business.


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Single Column System

Date Description Amount

Jan 1 Beginning Balance 1,000.00

Jan 2 Purchased shop supplies (150.00)

Jan 4 Performed repair service 275.00


Jan 15 Paid phone bill (50.00)

Jan 30 Ending balance 1,200.00

While extremely simple, because the above system uses a single column, only thedifference between revenues and expenses is totaled - not the individual values of each.Knowing the individual total amounts of revenues and expenses is important to a business,for example, when formulating a budget. The revenues and expenses also are reported inthe income statement. In the above example, the individual revenue and expense amountscan be determined only by sorting through the transactions and tabulating the revenue andexpense totals. This process can be designed into the system by using a separate columnfor revenues and expenses:

Separating Revenues and Expenses

Date Description Revenues Expenses

Jan 2 Purchased shop supplies 150.00



Jan 15 Paid phone bill 50.00

January Totals 400.00 200.00

While the above example now uses two columns, it still is considered to be a single-entrysystem since only one line is used to record each transaction in the cash account. Thissingle-entry system often is expanded to provide more useful information. For example,additional columns can be added to classify the revenues as sales and sales tax collected,and the expenses as rent, utilities, supplies, etc. Some single-entry systems may adddozens of columns for different types of revenues and expenses. Many small businessesutilize such a system. However, even with columns to classify the revenues and expenses,single-entry bookkeeping is limited in its ability to provide detailed financial information.Some disadvantages of a single-entry system include:

Does not track asset and liability accounts such as inventory, accounts receivable

and accounts payable. These must be tracked separately. Facilitates the calculation of income but not of financial position. There is no direct

linkage between income and the balance sheet. Errors may go undetected and often are identified only through bank statement

reconciliation.

Because of these drawbacks, a single-entry system is not practical for many organizationssuch as those having many thousands of transactions in a reporting period, significantassets, and external suppliers of capital. The more sophisticated double-entrybookkeeping system addresses the more demanding needs of such businesses.


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Double-entry accounting has the following advantages over single-entry:

Accurate calculation of profit and loss in complex organizations Inclusion of assets and liabilities in the bookkeeping accounts. Preparation of financial statements directly from the accounts Easier detection of errors and fraud

The Accounting Equation

The resources controlled by a business/agency are referred to as its assets. For a newbusiness, those assets originate from two possible sources:

Investors who buy ownership in the business or public agency Creditors who extend loans to the business or public agency

Those who contribute assets to the agency have legal claims on those assets. Since thetotal assets of the business are equal to the sum of the assets contributed by investorsand the assets contributed by creditors, the following relationship holds and is referred toas the accounting equation

Assets = Liabilities + Owners' Equity

Resources Claims on the Resources

Initially, owner equity is affected by capital contributions such as the issuance of stock.Once business operations commence, there will be income (revenues minus expenses,and gains minus losses) and perhaps additional capital contributions and withdrawals suchas dividends. At the end of a reporting period, these items will impact the owners' equity as

follows:

Assets = Liabilities + Owners' Equity

+ Revenues

- Expenses

+ Gains

- Losses

+ Contributions

- Withdrawals

These additional items under owners' equity are tracked in temporary accounts until theend of the accounting period, at which time they are closed to owners' equity.

The accounting equation holds at all times over the life of the business. When atransaction occurs, the total assets of the business may change, but the equation willremain in balance. The accounting equation serves as the basis for the balance sheet, asillustrated in the following example.


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The Accounting Equation

To better understand the accounting equation, consider the following example. Hassan Alidecides to open a bicycle repair shop To get started he rents some shop space, purchasesan initial inventory of bike parts, and opens the shop for business. Here is a listing of thetransactions that occurred during the first month:

Date Transaction

Sep 1 Owner contributes $7500 in cash to capitalize the business.

Sep 8 Purchased $2500 in bike parts on account, payable in 30 days.

Sep 15 Paid first month's shop rent of $1000.

Sep 17 Repaired bikes for $1100; collected $400 cash; billed customers for the $700 balance.

Sep 18 $275 in bike parts were used.

Sep 25 Collected $425 from customer accounts.

Sep 28 Paid $500 to suppliers for parts purchased earlier in the month.

These transactions affect the accounting equation as shown below.

Assets = Liabilities + Owner's Equity

Cash +Bike

Parts+

Accounts

Receivable=

Accounts

Payable+

Peddler,

Capital+

Revenue

(Expenses)

Sep 1 7500 = 7500

Sep 8 2500 = 2500

Sep 15 (1000) = (1000)

Sep 17 400 700 = 1100

Sep 18 (275) = (275)

Sep 25 425 (425) =

Sep 28 (500) = (500)

Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175)

$9325 = $9325

Note that for each date in the above example, the sum of entries under the "Assets"heading is equal to the sum of entries under the "Liabilities + Owner's Equity" heading. Inmost of these cases, the transaction affected both sides of the accounting equation.However, note that the Sep 25 transaction affected only the asset side with an increase incash and an equal but opposite decrease in accounts receivable.


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At the end of the month of September, the net income (revenues minus expenses) isclosed to capital and the balance sheet for the business would appear as follows:

Peddler's BikesBalance SheetSeptember 30, 20xx

Assets

Liabilities &

Owner's EquityCash 6825 Accounts Payable2000Accounts Receivable275 Peddler, Capital 7325Bike Parts 2225

Total Assets $9325 Total Liabilities $9325

The bike parts are considered to be inventory, which appears as an asset on the balancesheet. The owner's equity is modified according to the difference between revenues andexpenses. In this case, the difference is a loss of $175, so the owner's equity has

decreased from $7500 at the beginning of the month to $7325 at the end of the month.

Debits and Credits

The above example illustrates how the accounting equation remains in balance for eachtransaction. Note that negative amounts were portrayed as negative numbers. In practice,negative numbers are not used; in a double-entry bookkeeping system the recording ofeach transaction is made via debits and credits in the appropriate accounts.

The Accounting Cycle

The sequence of activities beginning with the occurrence of a transaction is known as theaccounting cycle. This process is shown in the following diagram:

Steps in the Accounting Cycle it is possible to number the stages and refer to thenext pages with the example.

Identify the TransactionIdentify the event as a transactionand generate the source document.

Analyze the TransactionDetermine the transaction amount,which accounts are affected,and in which direction.

Journal Entries


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The transaction is recorded inthe journal as a debit and a credit.

Post to LedgerThe journal entries are transferredto the appropriate T-accountsin the ledger.

Trial BalanceA trial balance is calculatedto verify that the sum of the debitsis equal to the sum of the credits.

Adjusting EntriesAdjusting entries are made foraccrued and deferred items.The entries are journalized andposted to the T-accountsin the ledger.

AdjustedTrial BalanceA new trial balance is calculatedafter making the adjusting entries.

Financial StatementsThe financial statementsare prepared.

Closing EntriesTransfer the balances of thetemporary accounts(e.g. revenues and expenses)to owner's equity.


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After-Closing

Trial BalanceA final trial balance iscalculated after the closingentries are made.

The above diagram shows the financial statements as being prepared after the adjustingentries and adjusted trial balance. The financial statements also can be prepared beforethe adjusting entries with the help of a worksheet that calculates the impact of theadjusting entries

The Source Document

When a financial transaction occurs, a document known as the source documentcaptures the key data of the transaction. The source document describes the basic facts of

the transaction such as its date, purpose, and amount.

Some examples of source documents:

cash receipt cancelled check invoice sent or received credit memo for a customer refund employee time sheet

The source document is the initial input to the accounting process and serves as objectiveevidence of the transaction, serving as part of the audit trail should the firm/agency need toprove that a transaction occurred.

To facilitate referencing, each source document should have a unique identifier, usually anumber or alphanumeric code. Prenumbering of commonly-used forms helps to enforcenumbering, to classify transactions, and to identify and locate missing source documents.A well-designed source document form can minimize errors and improve the efficiency oftransaction recording.

The source document may be created in either paper or electronic format. For example,automated accounting systems may generate the source document electronically or allowpaper source documents to be scanned and converted into electronic images. Accounting

software often provides on-screen entry forms for different types of transactions to capturethe data and generate the source document.

The source document is an early document in the accounting cycle. It provides theinformation required to analyze and classify the transaction and to create the journalentries.


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Journal Entries

After a transaction occurs and a source document is generated, the transaction isanalyzed and entries are made in the general journal. A journal is a chronological listingof the firm's/agencies transactions, including the amounts, accounts that are affected, andin which direction the accounts are affected. A journal entry takes the following format:

Format of a General Journal Entry

Date Accounts Debit Credit

mm/ddaccount to be debited xxxx.xx

account to be credited xxxx.xx

Single journal entry

In addition to this information, a journal entry may include a short notation that describesthe transaction. There also may be a column for a reference number so that thetransaction can be tracked through the accounting system.

The above format shows the journal entry for a single transaction. Additional transactionswould be recorded in the same format directly below the first one, resulting in a time-ordered record. The journal format provides the benefit that all of the transactions arelisted in chronological order, and all parts (debits and credits) of each transaction are listedtogether.

Because the journal is where the information from the source document first enters theaccounting system, it is known as the book of original entry.

Compound Journal Entries

The format shown above has a single entry for the debit and a single entry for the credit.This type of entry is known as a simple journal entry. Sometimes, more than twoaccounts are affected by a transaction so more than two lines are required. Such a journalentry is know as a compound journal entry and takes the following format:

Format of a Compound General Journal Entry


mm/ddaccount to be debited xxxx.xx



For example, if an expense is incurred in which part of the expense is paid with cash andthe remainder placed in accounts payable, then two lines would be used for the credit -one for the cash portion and one for the accounts payable portion. The total of the twocredits must be equal to the debit amount.

As many accounts as are necessary can be used in this manner, and multiple accountsalso can be used for the debit side if needed.


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Special Journals

The general journal is the main journal for a wide range of transactions. Of these, abusiness/agency usually finds itself performing some types much more frequently thanothers. By grouping specific types of transactions into their own special journal, theefficiency and organization of the accounting system can be improved.

Some commonly-used special journals:

sales journal purchases journal cash receipts journal cash disbursements journal

While a special journal may be organized differently from the general journal, it stillprovides the core transaction information such as date, debits and credits, and the relevantaccounts.

From Journal Entry to Ledger Posting

Once the source document is generated and the appropriate journal entry is made, thenext step in the accounting cycle is to post the entry to the general ledger.

The General Ledger

While the journal lists transactions in chronological order, its format does not faciliate thetracking of individual account balances. The general ledger is used for this purpose.

The general ledger is a collection of T-accounts to which debits and credits are

transferred. The action of recording a debit or credit in the general ledger is referred to asposting. The posting of a journal entry to the general ledger accounts is a purelymechanical process using information already in the journal entry and requiring noadditional analysis.

To understand the posting process, consider a journal entry in the following format:

General Journal Entry


mm/dd Account 1 xxxx.xx

Account 2 xxxx.xx

There are two ledger accounts affected by the above journal entry (Account 1 and Account2). Each of these accounts is represented by a T-account in the general ledger. To postthe entry to the ledger, simply transfer the information to the T-accounts:


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Ledger Accounts

Account 1

Mm/dd xxxx.xx

Bal. xxxx.xx

Account 2

mm/dd xxxx.xx

Bal. xxxx.xx

Note that the debit portion of the journal entry is posted to the left side of its associated T-account, and the credit portion is posted to the right side of its T-account. The date helpsto identify the transactions with the journal entries. Additionally, a reference number maybe added to further facilitate cross-referencing.

Because the general ledger is organized by account, it allows one to view the activity andbalance of any account at a glance.

Debits and Credits

In double entry accounting, rather than using a single column for each account andentering some numbers as positive and others as negative, we use two columns for eachaccount and enter only positive numbers. Whether the entry increases or decreases theaccount is determined by choice of the column in which it is entered. Entries in the leftcolumn are referred to as debits, and entries in the right column are referred to as credits.

Two accounts always are affected by each transaction, and one of those entries must be adebit and the other must be a credit of equal amount. Actually, more than two accountscan be used if the transaction is spread among them, just as long as the sum of debits for

the transaction equals the sum of credits for it.

The double entry accounting system provides a system of checks and balances. Bysumming up all of the debits and summing up all of the credits and comparing the twototals, one can detect and have the opportunity to correct many common types ofbookkeeping errors.

To avoid confusion over debits and credits, avoid thinking of them in the way that they areused in everyday language, which often refers to a credit as increasing an account and adebit as decreasing an account. For example, if our bank credits our checking account,money is added to it and the balance increases. In accounting terms, however, if atransaction causes a company's checking account to be credited, its balance decreases.Moreover, crediting another company account such as accounts payable will increase itsbalance. Without further explanation, it is no wonder that there often is confusion betweendebits and credits.

The confusion can be eliminated by remembering one thing. In accounting, the verbs"debit" and "credit" have the following meanings:

Debit


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"Enterin theleftcolumn

of" Cre

dit

"Enterin therightcolumnof"

Cr

edit

"Enterin therightcolumnof" Credit

"Enterin the

rightcolumnof"

Thatsall.Debitrefersto the

leftcolumn;creditrefersto therightcolumn. Todebit


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thecashaccountsimply

means toenterthevaluein theleftcolumn ofthecashaccount.Therearenodeepermeaningswithwhichto be

concerned.

Thereason fortheapparentinconsistency

whencomparingeverydaylanguage toaccountinglangu


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ng it.Incommonuse,we

usetheterminologyfromtheperspectiveof thebank'sbooks,hencetheapparentinconsistency.

Whether a

debitor acreditincreases ordecreasesanaccountbalance

depends onthetypeofaccount.Assetandexpen


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seaccountsareincreased

on thedebitside,andliability,equity, andrevenueaccountsareincreasedon thecreditside.Thefollowingchartserve

s as agraphicalreferenceforincreasinganddecreasingaccou

ntbalances:

Assets = Liabilities + Own


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er'sEquity = Liabilities + Owner'sEquity Liabilities + Owner'sEquity

+ Owner'sEquity Owner'sEquity

Cash

Debit

+

Credit

- Debit

+ Credit

-

Credit


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- Credit

-

A/P


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Debit

- Cr

edit

+ Debit

- Credit

+

Credit

+ Credit

+

RetainedEarnings


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Debit

- Cr

edit

+ Debit

- Credit

+

Credit

+ Credit

+

Expens

e

Debit


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+ Cr

edit

- Debit

+ Cr

edit

-

Cr

edit

- Credit

- Revenue

Revenue

Debit


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- Cr

edit

+ Debit

- Credit

+

Credit

+ Credit

+

Type of Account Accounting Effect

Cash/Bank Account : Debit will Increase and Credit will Decrease the cash balance.Accounts Payable : Debit will Reduce and Credit will Increase the Debt.Expenses : Debit will Increase and Credit will Decrease the Expenses.Revenue : Debit will Decrease and Credit will Increase the RevenueRetained Earnings : Debit will Decrease and Credit will increase the R. Earnings


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Trial Balance

A basic rule of double-entry accounting is that for every credit there must be an equal debitamount. From this concept, one can say that the sum of all debits must equal the sum ofall credits in the accounting system. If debits do not equal credits, then an error has beenmade. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts. Theaccount balances are used because the balance summarizes the net effect of all of thedebits and credits in an account. To calculate the trial balance, construct a table in thefollowing format:

Trial Balance Calculation

Account Debits Credits

Account 1 xxxx.xx

Account 2 xxxx.xx

Account 3 xxxx.xx

.

.

.

Account 4 xxxx.xx

Account 5 xxxx.xx

Account 6 xxxx.xx

..

.

________ ________

Totals: xxxx.xx xxxx.xx

In the above trial balance, the balances of Accounts 1, 2, and 3 are net debits, and thebalances of Accounts 4, 5, and 6 are net credits. The totals of the debits and creditsshould be equal; if they are not, then an error was made somewhere in the accountingprocess. Some common errors include the following:

1. Error in totaling the columns - make sure that the trial balance columns weresummed properly.

2. Error in transferring account balances to proper trial balance columns - makesure that debit and credit account balances are in the appropriate debit and creditcolumns of the trial balance calculation. Check for reversed digits and misplaceddecimal points.


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3. Omission of an account - an account may be missing in the trial balancecalculation.

4. Error in account balance - an error may have been made in the calculation of aledger account balance.

5. Error in posting a journal entry - a journal entry may not have been postedproperly to the general ledger.

6. Error in recording a transaction in the journal - for example, making an error in adebit or credit, or failing to enter a debit or credit.

In general, the most effective way to isolate an error is to work backward from the trialbalance itself to the initial journal entry, as outlined in the above list.

Note that a balanced trial balance does not guarantee that there are no errors. An error ofomission could have been made in which a transaction was not recorded, a journal entrycould have been posted to the wrong ledger account, or a debit and credit could havebeen transposed. Such errors are not caught by the trial balance.

Adjusting Entries

In the accounting process, there may be economic events that do not immediately triggerthe recording of the transaction. These are addressed via adjusting entries, which serveto match expenses to revenues in the accounting period in which they occur. There aretwo general classes of adjustments:

Accruals - revenues or expenses that have accrued but have not yet beenrecorded. An example of an accrual is interest revenue that has been earned in oneperiod even though the actual cash payment will not be received until early in thenext period. An adjusting entry is made to recognize the revenue in the period inwhich it was earned.

Deferrals - revenues or expenses that have been recorded but need to bedeferred to a later date. An example of a deferral is an insurance premium that waspaid at the end of one accounting period for insurance coverage in the next period.A deferred entry is made to show the insurance expense in the period in which theinsurance coverage is in effect.

How to Make Adjusting Entries

Like regular transactions, adjusting entries are recorded as journal entries. The followingillustrates adjustments for accrued and deferred items.

Accrued Items

As an example of an accrued item, consider the accrual of interest revenue. The journalentry would be similar to the following:

Adjusting Entry for Interest Accrual


mm/ddInterest Receivable xxxx.xx

Interest Revenue xxxx.xx


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The date of the above entry would be at the end of the period in which the interest wasearned. The adjusting entry is needed because the interest was accrued during that periodbut is not payable until sometime in the next period. The adjusting entry is posted to thegeneral ledger in the same manner as other journal entries.

In the next period when the cash is actually received, one makes the following journal

entry:

Journal Entry for Interest Received


mm/ddCash xxxx.xx

Interest Receivable xxxx.xx

Deferred Items

For deferrals, a journal entry already has been made in asset or liability accounts and anadjusting entry is needed to move the balances to expense or revenue accounts in thenext accounting period. Consider the case in which the firm prepays insurance premiumsin one period for insurance coverage in the next period. The journal entry made at the timeof payment would be similar to the following:

Journal Entry for Prepaid Insurance


mm/ddPrepaid Insurancexxxx.xx

Cash xxxx.xx

In the next period when the insurance coverage is in effect, one makes the followingadjusting entry:

Adjusting Entry for Prepaid Insurance


mm/ddInsurance Expense xxxx.xx

Prepaid Insurance xxxx.xx

For a single deferred item, there may be several adjusting entries over subsequentaccounting periods as the expense or revenue for the item is recognized over time.


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Closing Entries

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accountsthat are reset at the end of the accounting period so that they will have zero balances atthe start of the next period. Closing entries are the journal entries used to transfer thebalances of these temporary accounts to permanent accounts.

After the closing entries have been made, the temporary account balances will be reflectedin the Retained Earnings (a capital account). However, an intermediate account calledIncome Summary usually is created. Revenues and expenses are transferred to theIncome Summary account, the balance of which clearly shows the firm's income for theperiod. Then, Income Summary is closed to Retained Earnings.

The sequence of the closing process is as follows:

1. Close the revenue accounts to Income Summary.2. Close the expense accounts to Income Summary.3. Close Income Summary to Retained Earnings.

4. Close Dividends to Retained Earnings.

The closing journal entries associated with these steps are demonstrated below. Theclosing entries may be in the form of a compound journal entry if there are severalaccounts to close. For example, there may be dozens or more of expense accounts toclose to Income Summary.

1. Close Revenue to Income Summary

The balance of the revenue account is the total revenue for the accounting period. Sincerevenue is one of the components of the income calculation (the other component being

expenses), in the last day of the accounting period it is closed to the Income Summaryaccount as follows:

Closing Entry : Revenue to Income Summary


mm/ddRevenue xxxx.xx

Income Summary xxxx.xx

Once this closing entry is made, the revenue account balance will be zero and the account

will be ready to accumulate revenue at the beginning of the next accounting period.

2. Close Expenses to Income Summary

Expenses are the other component of the income calculation and like revenue, are closedto the Income Summary account:


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Closing Entry : Expenses to Income Summary


mm/ddIncome Summaryxxxx.xx

Expenses xxxx.xx

After closing, the balance of Expenses will be zero and the account will be ready for theexpenses of the next accounting period. At this point, the credit column of the IncomeSummary represents the firm's revenue, the debit column represents the expenses, andbalance represents the firm's income for the period.

3. Close Income Summary to Retained Earnings

The income or loss for the period ultimately adds to or subtracts from the firm's capital.The Retained Earnings account is a capital account that accumulates the income fromeach accounting period. The Income Summary account is closed to Retained Earnings asfollows:

Closing Entry : Income Summary to Retained Earnings


mm/ddIncome Summary xxxx.xx

Retained Earnings xxxx.xx

4. Close Dividends to Retained Earnings

Any capital withdrawals (e.g. dividends paid) during the period will reduce the capitalaccount balance, so the withdrawal is closed to Retained Earnings:

Closing Entry : Dividends to Retained Earnings


mm/ddRetained Earningsxxxx.xx

Dividends xxxx.xx

After closing, the dividend account will have a zero balance and be ready for the nextperiod's dividend payments.


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have been paid. For a sole proprietorship or a partnership, the equity would be listed asthe owner or owners' names followed by the word "capital". For example:

Sole Proprietorship: Mohamud Ahmed, Capital

Partnership: Mohamud Ahmed, Capital

Hassan Ali, Capital

In the case of a corporation, equity would be listed as common stock, preferred stock, andretained earnings.

The balance sheet reports the resources of the entity. It is useful when evaluating theability of the company to meet its long-term obligations. Comparative balance sheets arethe most useful; for example, for the years ending December 31, 2005 and December 31,2006.

Income Statement

The income statement presents the results of the entity's operations during a period oftime, such as one year. The simplest equation to describe income is:

Net Income = Revenue - Expenses

Revenue refers to inflows from the delivery or manufacture of a product or from therendering of a service. Expenses are outflows incurred to produce revenue.

Income from operations can be separated from other forms of income. In this case, theincome can be described by:

Net Income = Revenue - Expenses + Gains - Losses

where gains refer to items such as capital gains, and losses refer to capital losses, lossesfrom natural disasters, etc.

Statement of Owners' Equity(Statement of Retained Earnings)

The equity statement explains the changes in retained earnings. Retained earnings appearon the balance sheet and most commonly are influenced by income and dividends. TheStatement of Retained Earnings therefore uses information from the Income Statementand provides information to the Balance Sheet.

The following equation describes the equity statement for a sole proprietorship:

Ending Equity = Beginning Equity + Investments - Withdrawals + Income


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For a corporation, substitute "Dividends Paid" for "Withdrawals". The stockholders' equityin a corporation is calculated as follows:

Common Stock (recorded at par value)+ Premium on Common Stock (issue price minus par value)+ Preferred Stock (recorded at par value)

+ Premium on Preferred Stock (issue price minus par value)+ Retained Earnings----------------------------------------------------------------= Stockholders' Equity

Note that the premium on the issuance of stock is based on the price at which thecorporation actually sold the stock on the market. Afterwards, market trading does notaffect this part of the equity calculation. Stockholders' equity does not change when thestock price changes!

Cash Flow Statement

The nature of accrual accounting is such that a company may be profitable butnonetheless experience a shortfall in cash. The statement of cash flows is useful inevaluating a company's ability to pay its bills. For a given period, the cash flow statementprovides the following information:

Sources of cash Uses of cash Change in cash balance

The cash flow statement represents an analysis of all of the transactions of the business,reporting where the firm obtained its cash and what it did with it. It breaks the sources and

uses of cash into the following categories:

Operating activities Investing activities Financing activities

The information used to construct the cash flow statement comes from the beginning andending balance sheets for the period and from the income statement for the period.

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