The Conceptual Framework of Accounting

Assumptions
1. Time period Assume that economic information can be meaningfully captured and
communicated effectively over short periods of time
2. Economic Entity Financial matters and activities of a business can be separated from the
financial activities of the business's owner
3. Going Concern Assuming that a company will continue to operate in the foreseeable
future.
4. Monetary unit Assuming that the dollar, unadjusted for inflation, is considered the most
effective means of communication for economic activity.
Qualitative Characteristics
5. Understandability Accounting information needs to be comprehensible to those who have
a reasonable understanding of business, as well as the willingness to study the information
with reasonable diligence.
6. Relevance The capacity of accounting information to make a difference in decision
making.
7. Reliability The extent to which accounting information can be depended upon to
represent, what it purports to represent, in both description and numerically.
8. Comparability Using accounting information to compare or contrast the financial
activities of different companies.
a. Consistency Able to compare or contrast the financial activities of the same entity
over time.
b. Conservatism Manner in which accountants deal with uncertainty regarding
economic situations
c. Materiality Threshold at which a financial item begins to affect decision making
Principles
9. Revenue Recognition Revenues are recorded when they are earned
10.Matching Expenses recorded in the time period when they are incurred to generate
revenues
11.Cost Assets are recorded and maintained at their historical costs
Government Accounting - Trial Balance, Financial Reports and Statements
FINANCIAL REPORTING SYSTEM
Eight Steps in the Accounting Cycle:
1. Analyzing the transactions
2. Journalizing the transactions
3. Posting the journal entries
4. Preparation of Trial Balance
5. Adjusting the accounts
6. Closing the accounts
7. Preparation of Financial Statements
8. Reversing the accounts
New Government Accounting System
Two Subsystems
1. Preparation and submission of trial balances and other reports.
2. Preparation and submission of financial statements
TRIAL BALANCE
It is a listing of general ledger accounts with their corresponding debit and credit balances.
It is used to determine equality of debit and credit balances after the recording process.
It may be prepared anytime; usually before financial statements are prepared.
A two-money column trial balance is required under the new system.
PURPOSES
1. To prove the mathematical equality the debits and credits after posting.
2. To uncover errors in journalizing and posting.
3. To serve as basis for the preparation of the financial statements.
WORKSHEET

It is "a columnar sheet of paper on which accountants have summarized information

needed to make the adjusting and closing entries and to prepare the financial
statements."
It is also a useful tool for the auditor in the analysis and examination of the accounts.
1. Account Title and Code Columns (Title and Code)
2. Unadjusted Trial Balance Columns (Debit and Credit)
3. Adjustments Columns (Debit and Credit)
4. Adjusted/Pre-Closing Trial Balance Columns (Debit and Credit)
5. Closing Entries Columns (Debit and Credit)
6. Statement of Income and Expense Columns (Debit and Credit)
7. Post-Closing Trial Balance Columns (Debit and Credit)
8. Balance Sheet Columns (Debit and Credit)
Steps in Preparing the WORKSHEET:
1. Enter the titles and balances of the ledger accounts in the Pre-Closing Trial Balance
Column.
2. Enter the adjusting entries and the closing entries in the Adjustments Column.
3. Extend the adjusted account balances in the Post-Closing Trial Balance column.
4. Extend the adjusted balances of the expense and income accounts to the Statement of
Income and Expenses column.
5. Extend the adjusted balances of the assets, liabilities and equity accounts to the Balance
Sheet Statement column.
ADJUSTING JOURNAL ENTRIES
Revenue and expenses are adjusted to reflect economic activities that have taken place,
but are not yet considered when the financial statements were prepared.
To ensure that revenue and expenses are recorded in the period when they are earned or
incurred
TWO MAIN TYPES OF ADJUSTMENTS
1. Accrued items
2. Deferred items
ACCRUED ITEMS These are adjusting entries for economic activities already undertaken but
not yet recorded as asset and revenue accounts or a liability and expense accounts.
a.) ASSET / REVENUE ADJUSTMENTS
Illustration: (Interest Income)
The interest receivable account of Agency ABC for the interest already earned but not yet
collected nor billed as of the end of the year amounts to P2,000. The journal entry will be
as follows:
Account Title
Account Code
Debit
Credit
Interest Receivable
129
2000
Interest Income
664
2000

b.) LIABILITY / EXPENSE ADJUSTMENTS ASSET/REVENUE ADJUSTMENTS LIABILITY/

EXPENSE ADJUSTMENTS
Illustration: (Accrued Salaries)
As of year-end, Agency ABC has not yet paid salaries and wages of P25,000, which covers
the period December 16-31, 2004.
Account Title
Account Code
Debit
Credit
Salaries and Wages 701
25000
Regular
Due to Officers and
123
25000
Employees

DEFERRED ITEMS - These are adjusting entries transferring data previously recorded in asset
account to expense
account or data previously recorded in liability account to revenue account.

a.) ASSET / EXPENSE ACCOUNT

Illustration: (Prepaid Expenses)
Agency ABC has prepaid expenses in the amount of P20,000, portion of which were
utilized or consumed in the amount of P5,000. Since the original entry was debited to
Prepaid account, the adjusting entry would be:
Account Title
Account Code
Debit
Credit
Rent Expenses
782
5000
Prepaid Rent
177
5000

b.) LIABILITY / REVENUE ACCOUNT

Illustration:
The agency collected an amount of P15,000 for the rent of its facility and originally
recorded it as deferred credit to income. At the end of the fiscal year, only P3,000 was
earned. The adjusting journal entry to recognize the earned portion would be:
Account Title
Account Code
Debit
Credit
Other Deferred Credits
455
3000
Rent Income
642
3000

CLOSING ENTRIES
1. Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts
that are reset at the end of the accounting period so that they will have zero balances at
the start of the next period. Closing entries are the journal entries used to transfer the
balances of these temporary accounts to permanent accounts.
2. After the closing entries have been made, the temporary account balances will be
reflected in the Retained Earnings (a capital account). However, an intermediate account
called Income Summary usually is created. Revenues and expenses are transferred to the
Income Summary account, the balance of which clearly shows the firm's income for the
period. 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.
Close Revenue to Income Summary
The balance of the revenue account is the total revenue for the accounting period.
Since revenue 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 Summary account as follows:
Closing Entry : Revenue to Income Summary
Revenue
XXX
Income Summary
XXX

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.

Close Expenses to Income Summary

Expenses are the other component of the income calculation and like revenue, are
closed to the Income Summary account:
Closing Entry : Expenses to Income Summary

Income Summary
Expenses

XXX
XXX

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

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 from
each accounting period. The Income Summary account is closed to Retained Earnings
as follows:
Closing Entry : Income Summary to Retained Earnings
Income Summary
XXX
Retained Earnings
XXX
Close Dividends to Retained Earnings
Any capital withdrawals (e.g. dividends paid) during the period will reduce the capital
account balance, so the withdrawal is closed to Retained Earnings:
Closing Entry : Dividends to Retained Earnings
Retained Earnings
XXX
Dividends
XXX

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

Posting of the Closing Entries

1. As with other journal entries, the closing entries are posted to the appropriate general
ledger accounts. After the closing entries have been posted, only the permanent accounts
in the ledger will have non-zero balances.
Post-Closing Trial Balance
2. Once the closing entries have been posted, the trial balance calculation is performed to
help detect any errors that may have occurred in the closing process.
GENERATION OF FINANCIAL STATEMENTS AND SUPPORTING SCHEDULE
3. Once the adjusting entries have been made or entered into a worksheet, the financial
statements can be prepared using information from the ledger accounts.
Because some of the financial statements use data from the other statements, the
following is a logical order for their preparation:
1.
2.
3.
4.

Income statement
Statement of retained earnings
Balance sheet
Cash flow statement

Income Statement
The income statement reports revenues, expenses, and the resulting net
income. It is prepared by transferring the following ledger account balances,
taking into account any adjusting entries that have been or will be made:
Revenue
Expenses
Capital gains or losses Statement of Retained Earnings
Statement of Retained Earnings

The retained earnings statement shows the retained earnings at the beginning
and end of the accounting period. It is prepared using the following information:
Beginning retained earnings, obtained from the previous statement of
retained earnings.
Net income, obtained from the income statement
Dividends paid during the accounting period Balance Sheet

Balance Sheet
The balance sheet reports the assets, liabilities, and shareholder equity of the
company. It is constructed using the following information:

Balances of all asset accounts such cash, accounts receivable, etc.

Balances of all liability accounts such as accounts payable, notes, etc.
Capital stock balance
Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

The cash flow statement explains the reasons for changes in the cash balance,
showing sources and uses of cash in the operating, financing, and investing
activities of the firm. Because the cash flow statement is a cash-basis report, it
cannot be derived directly from the ledger account balances of an accrual
accounting system. Rather, it is derived by converting the accrual information to
a cash-basis using one of the following two methods:
1. Direct method
Cash flow information is derived by directly subtracting cash
disbursements from cash receipts.
2. Indirect method
Cash flow information is derived by adding or subtracting non-cash
items from net income. Income Statement
RESPONSIBILITY FOR FINANCIAL STATEMENTS
The responsibility for the fair presentation and reliability of financial Statement of income
and expenses statements rests with the reporting agencys Management.

This responsibility shall be discharged:

1. By applying generally accepted state accounting principles
2. By maintaining effective system of internal control
3. By strict adherence to the chart of accounts prescribed by the Commission on Audit

To achieve fair presentation and reliable information of the financial statements, the
following standards shall be observed:
Fairness of presentation
Compliance
Timeliness
Usefulness

Statement of management responsibility for financial statement

Serves as the cover letter in transmitting the agencys financial statements to the
Commission on Audit, Department of Budget and Management, other oversight agencies
and other parties.

It acknowledges the agencys responsibility for the preparation and presentation of the
financial statements.

Signed by the Director of Finance and Management Office or Comptrollership Office, of the
Chief of Office, who has direct supervision and control over agencys accounting and
financial transactions, and the Head of Agency or his authorized representative
Commission on audit
mandated under- Article IX-D of the 1987 Philippine Constitution to submit
to the Office of the President and the Congress, and annual report on the

financial condition and on the results of operations of all agencies of the

government not later than September 30 each year.
Types of financial statements
1. Chief Accountants/Head of Accounting Unit
2. Government Accountancy and Financial Management Information System (GAFMIS)
Sector
The following yearend financial statements and reports/schedules in PRINTED and DIGITAL copies
on or before February 14 of each year pursuant to GAFMIS Circular Letter No. 2003-007 dated
December 19, 2003.
1. Pre-closing trial balance
2. Post-closing trial balance
3. Detailed and condensed statement of income and expenses
4. Detailed and condensed balance sheet
5. Statement of changes in government equity
6. Statement of cash flows (DIRECT METHOD)
7. Notes to financial statements
8. Statement of management responsibility
9. Detailed breakdown of obligations
10.Detailed breakdown of disbursements
11.Report of income national government books
12.Report of income regular agency books
13.Regional breakdown of income
14.Regional breakdown of expenses
15.Schedule/aging of accounts payable
16.Schedule/aging of accounts receivable
17.Schedules of public infrastructures/ reforestation projects
The new accounting system shall require the following financial statements:
Balance sheet
-Assets
- Liabilities
- Equity

Transcript of Copy of Government Accounting Chapter 7 - Trial Balance, Financial

Reports and Statements
Reports and Statements Financial Reporting System.
.
Statement of Cash Flows - It is a statement summarizing all the
cash activities of an agency. This
includes the operating, investing and
financing activities of the entity and
provides information on the cash
receipts and cash payments during
the period. Preparation of Statement of Cash Flows -To facilitate the preparation of the Statement
of Cash Flows, the use of a Working Paper is encouraged. It shall show the increase or decrease
in the cash accounts between two periods. The net increase in cash provided by 1) operating 2)
investing and 3) financing activities in addition to the cash balance at the beginning shall equal
to the cash balance at the end of the period.
1.) Operating Activities
2.) Investing Activities
3.) Financing Activities Cash flows from Operating Activities Cash Inflows: Receipt of Notice of
Cash allocation (NCA) from the DBM
Receipt of Notice of Transfer of Allocation to Agency RO/OU from CO
Cash receipts from all sources of revenues
Receipt of Interagency cash transfers (Due to)

Cash receipts from the sale of goods or rendition of services

Cash receipt of interest income, rental income, dividend income, etc.
Receipt of payment for liquidated damages
Receipt of refund of deposits
Receipt of refunds of cash advance or excess payments
Collection of receivables
Cash receipt of grants and donations
Receipt of cash dividends from enterprises (e.g. PLDT) Cash Outflows:
Payments of accounts payable
Cash purchase of merchandise for sale
Cash advances granted for travel
Inter-agency transfers (Due from)
Notice of Transfer of Allocation to Agency RO/OU issued by the NGA Main Office to RO/OU and/or
attached agencies through Government Servicing Banks
Return of unused NCA
Cash payment for operating expenses
Remittance of taxes withheld not covered by TRA and other deductions (if any)
Cash purchase of supplies and equipment
Cash payment of retirement benefits
Cash payment of claims for damages
Cash payment for liabilities incurred in operations
Cash payments for interest Cash flows from Investing Activities: Cash Inflows: Proceeds from
sale of marketable stocks and bonds
Cash proceeds from the sale/disposal of equipment and other property, plant and equipment
Redemption of long-term investments or repayment by GOCC/GFI of long-term loans Cash
Outflows: Purchase of property, plant and equipment
Purchase of land
Investment in stocks/bonds
Investment in GOCC/GFIExposure as other long-term investments Cash flows from Financing
Activities: Cash Inflows: Cash received from domestic and foreign loans
Issuance of treasury bills Cash Outflows: Payment of domestic and foreign loans
Redemption of treasury bills outstanding
Payment of cash dividend Notes to Financial Statements - Integral parts of financial statements,
which
pertain to additional information necessary for fair presentation in conformity with generally
accepted accounting principles.
- It explains the headings captions or amounts in the statements of present information that
cannot be expressed in money terms, and description of accounting policies. The Four Types of
Disclosure 1. Customary or routine disclosure 2. Disclosure of changes in accounting principles Changes in accounting principles, practices, or the methods of
applying them, together with the financial effect, and the
justification for the change shall be disclosed in the financial
statements or a note thereto. - Information about measurement bases of important assets,
restrictions on assets and government equity, important long-term commitments not recognized
in the body of the statements, information on terms of owners equity and long-term debt, and
certain other disclosures required by pronouncements of the Philippine Institute of Certified
Public Accountants, Accounting Standards Council, and regulatory bodies that have jurisdiction
are necessary for full disclosure. 3. Disclosure of subsequent events - Disclosure of events that
affect the agency directly and that occur between the date of, or end of the period covered by,
the financial statements and the date of completion of the statements is necessary if knowledge
of the events might affect the interpretation of the statements, even though the events do not
affect the propriety of the statements. 4. Disclosure of accounting policies - Description of the
accounting policies adopted by the reporting entity is required as an integral part of the financial
statements. It is usually captioned "Summary of Significant Accounting Policies", and placed as
first item in the Notes. It shall be limited to description of the policies and no quantitative data
shall be included. Interim Reports = Interim reports are the financial statements required to be
prepared at any given period or at a financial
reporting period without closing the books of accounts. The following interim financial

statements shall be prepared and submitted quarterly with the Notes to Financial Statements:
a.) Statement of Income and Expenses;
b.) Balance Sheet; and
c.) Statement of Cash Flows. Worksheet - A worksheet is a tool for accumulating
and sorting information needed for the preparation of the financial statements. It is a columnar
sheet used to adjust and close account balances in preparation for the preparation of the
financial statements. The format of the worksheet shall be as follows: a.) Account Title and Code
columns show the accounts of the General Ledger.
b.) The Unadjusted Trial Balance columns reflect the amount balances of the General Ledger
accounts.
c.) Adjustments columns show adjusting journal entries effected for the accounts.
d.) Adjusted/Pre-Closing Trial Balance columns show the balances of all the accounts after
adjustments are added/deducted from the balances of accounts in the unadjusted trial balance.
e.) Closing Entries debit and credit columns show the amounts debited and credited to close the
nominal accounts.
f.) Statement of Income and Expenses columns show all the debit and credit amount balances of
the nominal accounts (subsidies, income and expenses) and intermediate accounts.
g.) Post-Closing Trial Balance columns show the debit and credit amount balances of all accounts
after posting the closing entries.
h.) Balance Sheet columns show all the debit and credit amount balances of all real accounts in
the post-closing trial balance (assets, liabilities and government equity).

= Taken directly from year-end Post closing trial balance and presented in detailed and
condensed form. The balance sheet shall be supported with the following schedules/statements:
- Schedules of accounts receivable (SAR)
- Schedules of accounts payable (SAP)
- Schedules of public infrastructures (SPI)
- Other schedules as may be required
= Statement of Allotments, Obligations and Balances (SAOB) shall be submitted to the
Commission on Audit by the Budget Officer/Agency Officer concerned. Statement of income and
expenses - shows the results of operation/performance of the agency at the end of a particular
period. Statement of government equity - shows the financial transactions, which resulted to the
change in government equity account at the end of the year.

Financial Accounting Basics

Accounting in general deals with identifying business activities, like sales to customers,
recording these activities, like journalizing, and communicating these activities with people
outside the organization with financial statements.

Financial accounting's main purpose is to provide useful, financial information to people or

groups outside of companies often called external users. External users need financial
information about companies in order to support their financial decisions.

The ultimate goal of financial accounting is to compile business transactions and other
input documents like invoices and sales receipts in the form of general purpose financial
statements that can be understood by external users.

Financial accounting aims as providing financial information that is reliable, relevant, and
comparable to these external users.

Different Types of Financial Statement Users

Here is a list of the most common external users of financial information and how they use it.
1. Shareholders or Investors
Shareholders and other investors are usually the first group of external users that comes to mind.
Investors in general want to assess the value of a company in order to decide whether it is worth
buying, selling, or holding their stock. Investors read financial statements to help predict future
performance and company worth.
2. Lenders or Creditors
Lenders or creditors also use financial statements to base the decisions on because they want to
know if a company is creditworthy enough to pay off its current loans or borrow additional funds.
Creditors study financial statements in order to analyze the liquidity and sustainability of a
company.
3. Customers
It might sound unlikely, but many customers study financial statements before making major
purchases. For instance, large companies like GM will study financial statements of their potential
suppliers in order to make sure they are fiscally sound. A company, like GM, benefits from longterm relationships with its suppliers. It wants to make sure of potential suppliers' longevity before
it goes into business with them.
4. Suppliers
Suppliers also use the financial statements of customers to judge whether they are creditworthy
enough to extend credit. For example, if a customer orders 100,000 units from a supplier, the
supplier wants to know whether the customer will be able to pay for these units before the
supplies incurs the expense of producing them.
5. Regulators
Regulators like the SEC, PCAOB, and IRS use company financial statements to make sure the
companies are following applicable laws. The SEC and PCAOB monitor publicly traded companies
to reduce fraudulent business activities; whereas, the IRS is mainly focused on tax collection and
compliance.
6. Unions
Labor unions use financial information to judge whether employee wage rates and benefit
packages are fair. They also use this information to assess future job prospects and bargain for
higher wages and better benefits.
7. Brokers and Analysts
Brokers and analysts are often potential investors that use financial information about companies
to chart performance trends and growth rates. These external users create reports that influence
current investors opinions and actions.
8. Press
Finally, the last main external user is the press. Although the press doesn't use financial
information for its decision bases, it does report on the financial information of companies.

Networks like Yahoo Finance and MSN Money are multi-million dollar businesses that simply
report financial information about other companies.

Conceptual Framework of Accounting (Accounting Principles)

Accounting principles are the building blocks for GAAP. All of the concepts and standards
in GAAP can be traced back to the underlying accounting principles.

The main accounting principles, concepts, assumptions, and constraints

1. Business Entity Concept
The business entity concept, also known as the economic entity principle, states
that all business entities should be accounted for separately. In other words,
businesses, related businesses, and the owners should be accounted for separately.
The owner and the business are two separate entities and should be accounted for
separately. The same goes for partnership and corporations.
Examples:
A. Mike, a partner in Big House Realty, LLC, often uses his company credit card for
personal expenses like dry cleaning and new clothes. He insists that these are
business expenses because he must wear new clothes in order to show houses.
Unfortunately, these are not business expenses. Clothing is a personal expense and
can't be recorded in the company financial statements. This would violate the
business entity concept. Instead, these transactions should be accounted for as an
owner withdrawal.
B. Jim, an owner of a pizza shop, decides to buy a new delivery car. Since the company
was low on cash, Jim decided to pay for the car himself out of his personal bank
account. Jim intends to add the car to the balance sheet of the pizza shop. The
economic entity principle requires Jim and his company to keep activities separated,
so the car must remain a personal vehicle unless Jim contributes it to the company
or the company buys it from Jim personally.
2. Going Concern Concept
The going concern concept or going concern assumption states that businesses
should be treated as if they will continue to operate indefinitely or at least long
enough to accomplish their objectives.
In other words, the going concern concept assumes that businesses will have a
long life and not close or be sold in the immediate future.
The going concern concept is extremely important to generally accepted accounting
principles. Without the going concern assumption, companies wouldn't have the
ability to prepay or accrue expenses.
Examples:
A. Assume Microsoft is currently suing a small tech company for copyright violation
over its software package. Since this software package is the only operation the
small tech company does, losing this lawsuit would be detrimental. There is a 95
percent expectation that Microsoft will win the lawsuit. The small tech company is
not a going concern because it is probable they will be out of business after the
lawsuit is settled.
B. In 2011, Gibson Guitar Factory was raided by the Federal government for illegally
smuggling endangered wood into the country. The Federal government took more
than $250,000 worth or Gibson's inventory and slapped them with large fines for
violating international laws. Gibson is still considered a going concern, because it is
not likely the fines and punishment will stop its operations.

3. Monetary Unit Assumption

The monetary unit assumption assumes that all business transactions and
relationships can be expressed in terms of money or monetary units.
Money is the common denominator in all economic activity and financial
transactions. That is why we assume that money is a good basis for comparing
companies and other accounting measurements.
In other words, accounting looks at transactions that can be communicated in
money or monetary units.
Examples:
A. A manufacturing plant is started in 1955. It acquires a piece of land and builds a
small factory on the land costing $50,000 in 1955. Today, this piece of land and
building is worth over $1,000,000 because of inflation. The monetary unit
assumption does not take into consideration inflation. The balance sheet of this
company will still show the land and building at historical cost unadjusted for
inflation.
B. During the middle of the night a retailer's store is vandalized. The sign is spraypainted over, the windows are broken, and some merchandise is stolen. The
retailer's financial statements will only report a loss on the damaged property. It
will not report lost potential sales due to down time wait for repairs or additional
inventory because of the monetary unit assumption. Lost sales are hypothetical
and can't be measured in real monetary units.
4.

Periodicity Assumption or Time Period Assumption

The periodicity assumption or time period assumption states that businesses can
divide up their activities into artificial time periods.

The time period assumption allows us to prepare financial statements on a monthly,

quarterly, and annually basis.

5. Historical Cost Principle

The historical cost principle states that businesses must record and account for
most assets and liabilities at their purchase or acquisition price. In other words,
businesses have to record an asset on their balance sheet for the amount paid for
the asset.
The asset cost or price is then never adjusted for changes in the market or economy
and changes due to inflation.
Examples:
A. Pam's Restaurant, LLC was formed in 1945. It purchased a building soon after in
1946 for $20,000. Total, some 50 plus years later, Pam's is still in business. The
original building is still on the balance sheet for $20,000 even though the current
fair market value of the building is well over $200,000. Pam's will keep the
building on its balance sheet for $20,000 until it is either retired or sold.
B. Jeff's Construction, LLC bought a piece of equipment in 2001 for $10,000. Today
this piece of equipment is only worth $2,000. Jeff would still report the
equipment at its purchase price of $10,000, less depreciation, even though its
current fair market value is only $2,000.
6.

Revenue Recognition Principle

The revenue recognition principle states that revenue should be recognized and
recorded when it is realized or realizable and when it is earned.
This is a key concept in the accrual basis of accounting because revenue can be
recorded without actually being received.
Revenues are realized or realizable when a company exchanges goods or services
for cash or other assets
Examples:

A. Bob's Billiards, Inc. sells a pool table to bar on December 31 for $5,000. The pool
table was not paid for until January 15th and it was not delivered to the bar until
January 31. According to the revenue recognition principle, Bob's should not
record the sale in December. Even though the sale was realizable in that the sale
for $5,000 was initiated, it was not earned until January when the pool table was
delivered.
B. Pat's Retail, Inc. sells clothing from its retail outlets. A customer purchases a shirt
on June 15th and pays for it on a credit card. Pat's processes the credit card but
does not actually receive the cash until July. The credit card purchase is treated
the same as cash because it is a claim to cash, so the revenue should be
recorded in June when it was realized and earned.
7. Matching Principle
The matching principle states that expenses should be recognized and recorded
when those expenses can be matched with the revenues those expenses helped to
generate.
The matching principle also states that expenses should be recognized in a "rational
and systematic" manner. This is the key concept behind depreciation where an
asset's cost is recognized over many periods.
Examples:
A. Angle Machining, Inc. buys a new piece of equipment for $100,000 in 2015. This
machine has a useful life of 10 years. This means that the machine will produce
products for at least 10 years into the future. According to the matching
principle, the machine cost should be matched with the revenues it creates.
Thus, the machine is depreciated over its 10-year useful life instead of being
fully expensed in 2015.
B. Big Appliance has sold kitchen appliances for 30 years in a small town. It
purchases a large appliance from wholesalers for $5,000 and resells it to a local
restaurant for $8,000. At the end of the period, Big Appliance should match the
$5,000 cost with the $8,000 revenue.
8. Full Disclosure Principle
The full disclosure principle states that information that would "make a difference"
to financial statement users or would be useful in decision-making should be
disclosed in the financial statements. This way investors or creditors can see a total
picture of the company before they choose to take any action.
Example:
A. Guitar Emporium is a nationwide guitar retailer. It reports $10.5M in guitar
inventory last year. In the notes of its financial statements, GE should disclose its
significant accounting policies. This would include its inventory evaluation
methods. GE should disclose whether its financial statements are prepared uses
FIFO or LIFO inventory cost methods.
B. Lake Real Estate, LLC purchased a piece of property from a foreclosure. A few
months after the purchase, someone slipped and fell on the property and
became seriously injured. The injured party is currently suing Lake Real Estate
for negligence. It is probably that LRE will lose the lawsuit. In this case, LRE
should disclose the lawsuit in the footnotes.
9. Cost Benefit Principle
The cost benefit principle or cost benefit relationship states that the cost of
providing financial information in the financial statements must not outweigh the
benefit of that information to the users.
The cost benefit principle is a common sense rule. Management can ask, "Does it
make sense to gather this financial information to put it in financial statement? Do
the costs of gathering this information outweigh the benefit to the users?"

Essentially, do users need this information enough to spend this money getting it? If
the answer is yes, the company can leave the information out of the financial
statements.
Example:
A. Paul's Retail, LLC discovered that an employee was stealing from its cash
register. The amount is suspected to be over $1,000, but Paul is not sure. It's
estimated that Paul would pay his accountant and attorney $5,000 to dig
through his records and discover the exact amount of the theft. In this case, it
would not be beneficial for Paul to do further research and sue his former
employee.
10.Materiality Concept
The materiality concept, also called the materiality constraint, states that financial
information is material to the financial statements if it would change the opinion or
view of a reasonable person. In other words, all important financial information that
would sway the opinion of a financial statement user should be included in the
financial statements.
The main question that the materiality concept addresses is does the financial
information make a difference to financial statement users. If not, the company
doesn't have to worry about including it in their financial statements because it is
immaterial.
Examples:
A. A large company has a building in the hurricane zone during Hurricane Sandy.
The company building is destroyed and after a lengthy battle with the insurance
company, the company reports an extra ordinary loss of $10,000. The company
has net income of $10,000,000. The materiality concept states that this gain is
immaterial because the average financial statement user would not be
concerned with something that is only .1% of net income.
B. Assume the same example above except the company is a smaller company
with only $50,000 of net income. Now the loss is 20% of net income. This is a
substantial loss for the company. Investors and creditors would be concerned
about a loss this big. To the smaller company, this $10,000 would be considered
material.
C. A small company bookkeeper doesn't do a very good job of keeping track of
expenses. Most random expenses get recorded in the miscellaneous expense
account. At the end of the year the miscellaneous expense account has a total of
$1424.25 in it. The total net income of the company is $36,940. The
miscellaneous account is immaterial to the overall financial picture of the
company and there is no need to reclassify the expenses in it.
11.Industry Practices Constraint
The industry practices constraint, also called the industry practices concept, states
that the nature of certain industries and their practices can require the departure of
traditional accounting theory. In other words, some industries have practices unlike
any other that require specialized accounting or reporting. The industry practices
constraint allows these industries to go outside of traditional accounting principles
as long as it is infrequent and justifiable.

Most industry practices that depart from traditional GAAP only conflict with one or
two accounting principles. In other words, an industry can't completely disregard
GAAP because of their specialized practices. They can bend one or two accounting
principles for good reasons.

This makes sense because every industry is different and faces different financial
reporting challenges. Every industry wouldn't be able to follow the same exact
guidelines and rules without incurring significant costs. The industry practices
constraint goes hand in hand with the cost benefit principle. Sometimes conforming

to GAAP is too costly for some industries, so they have adopted slightly modified
practices.
Examples
A. The agriculture industry reports its crops at their fair market value on the balance
sheet instead of the traditional historical cost or production cost. This is common
because calculating the actual cost per crop is too difficult and costly. Its easier for
farmers to value and report their crops at the current market price.
B. Most public utility companies report all non-current assets before current assets on
their balance sheets. The utility industry presents its balance sheet this way to
emphasize the fact that it is highly capitalized. In other words, utility companies
want to show financial statement users that they have large investments in longterm assets, so they report them first on the balance sheet.
12.Conservatism Principle
The principle of conservatism gives guidance on how to record uncertain events and
estimates. The principle of conservatism states that you should always error on the
most conservative side of any transaction. Most of the time this means minimizing
profits by recording uncertain losses or expenses and not recording uncertain or
estimated gains.
Since accounting standards and GAAP are always concerned with the usefulness of
financial data to financial statement users, you can understand why the FASB
doesn't want financial information to overestimate or error on the high side. This
could sway users' decisions.

The principle of conservatism also applies to estimates. Generally, a more

conservative estimate should always be used. When estimating allowance for
doubtful accounts, casualty losses, or other unknown future events you should
always error on the side of conservatism. In other words, you should tend to take
the position that is records the most expenses and least income. This is the main
principle behind the lower of cost or market concept for recording inventory.

Remember when there is an event with an uncertain outcome, you want to recognize
revenues when they are actually earned and recognize expenses when they are
reasonably probable.

Examples
A. Assume Gold Guitar, Inc. is in the middle of a patent lawsuit. GGI is suing Blue
Guitar, Inc. for patent infringement and anticipates winning a large settlement.
Since the settlement is not certain, GGI does not record the gain on the financial
statements. Why? Because of the GGI might not actually see this gain. It might
not win, or they might not win as much as it expected. Since a large winning
settlement might skew the financial statements and mislead the users, the gain
is left off the books.
B. Assume the same example above except GGI anticipates losing the lawsuit
instead of winning it. If Blue Guitar, Inc. expects to lose the suit; they should
record the loss in the footnotes of its financial statements. This would be the
most conservative approach because financial statement users want to know if
the company will have to pay out a large sum of money in the near future.
C. Red Brick Records is getting ready to release a new album and is unsure as to
whether it owes a few artists on the record royalties due to contracts and legal
disputes. Red Brick should report the contingent liability in the footnotes of the
financial statements. If the record is a hit, the record label could owe a large
amount of money to its artists. To be conservative, this should be shown in the
notes.

13.Objectivity Principle
The objectivity principle states that accounting information and financial reporting
should be independent and supported with unbiased evidence. This means that
accounting information must be based on research and facts, not merely a
preparer's opinion. The objectivity principle is aimed at making financial statements
more relevant and reliable.

The concept of relevance implies that financial statements can have predictive
value and feedback value. This means the financial statements are accurate and
can be used to predict future company performance.

The concept of reliability implies that financial information can be verified by many
sources with evidence and that all financial information is presented. In other words,
the favorable and unfavorable financial information is presented in the financial
statements.

The two concepts of relevance and reliability encompass the objectivity principle. By
making financial statements more relevant and reliable, the objectivity principle
makes the financial information more usable for investors and creditors.

The objectivity principle extends to internal auditors and CPA firms as well. Although
auditors must adhere to GAAS, auditors must be independent of the company they
are auditing. This helps ensure that the financial reporting and audits are done
objectively. Since investors and creditors rely on auditor's reports, the reports
should be independent. If management or current shareholders wrote reports and
audits, they would tend to be too optimistic and not rely on pure facts.

Examples
A. A company is trying to get financing for an extra plant expansion, but the
company's bank wants to see a copy of its financial statements before it will loan
the company any money. The company's bookkeeper prints out an income
statement from its accounting system and mails it to the bank. Most likely the
bank will reject this financial statement because an independent party did not
prepare it. In other words, this income statement violates the objectivity
principle.
B. Jim is an accountant who is the CFO of Fisher Corp. He leaves the company after
he is offered a partnership position in DHI and Associates, an audit firm. After six
months of working at the firm, he is assigned to the head auditor position on the
Fisher Corp audit. This is a violation of many GAAS rules, but it is also a violation
of the objectivity principle.
C. Nancy is an accountant in charge of preparing financial statements for Big Ben,
Inc. Nancy asks for Big Ben's records to support its payables and receivables, but
Big Ben says it will be too much work to get. Big Ben says to go with the
numbers in the accounting system. This is a violation of the objectivity principle
because the financial statements must be based on verifiable and reliable
records-- not someone's opinion.
14.Consistency Principle
The consistency principle states that companies should use the same accounting
treatment for similar events and transactions over time. In other words, companies
shouldn't use one accounting method today, use another tomorrow, and switch
back the day after that. Similar transactions should be accounted for using the
same accounting method over time. This creates consistency in the financial
information given to creditors and investors.

The consistency principle does not state that businesses always have to use the
same accounting method forever. Companies are allowed to switch accounting
methods if the company can demonstrate why the new method is better than the
old method. The company then must disclose the change in its financial statement
notes along with the effect of the change, date when the change occurred, and the
justification for the accounting method change.

As you can see, the consistency principle is intended to keep financial statements
similar and comparable. If companies changed accounting methods for valuing
inventory every single year, investors and creditors wouldn't be able to compare the
company's financial performance or financial position year after year. They would
have to recalculate everything to make the financial statements equivalent to each
other.

Examples
A. Bob's Computers, a computer retailer, has historically used FIFO for valuing its
inventory. In the last few years, Bob's has become quite profitable and Bob's
accountant suggests that Bob switch to the LIFO inventory system to minimize
taxable income. According to the consistency principle, Bob can change
accounting methods for a justifiable reason. Whether minimizing taxes is a
justifiable reason is debatable.
B. Assume Bob's Computers switched from FIFO to LIFO in year 2. In year 3, Bob's
income is extremely loan and Bob is trying to show a profit to get another bank
loan. Bob asks his accountant to switch from LIFO back to FIFO. This is a violation
of the consistency principle. Bob can make a justifiable change in accounting
method like in the first example, but he cannot switch back and forth year after
year.
C. Ed's Lakeshore Real Estate buys software licenses for its property listing
programs every year. Ed usually has to buy at least 10 licenses that cost
$15,000 a piece. Ed's capitalizes these licenses and amortizes them in the years
he doesn't need a deduction and he expenses them in the years that he needs a
tax deduction. This violates the consistency principle because Ed uses different
accounting treatments for the same or similar transactions over time.
Accounting Cycle

Accounting cycle is the financial process starting with recording business transactions and
leading up to the preparation of financial statements.
This process demonstrates the purpose of financial accounting--to create useful financial
information in the form of general-purpose financial statements.
The sole purpose of recording transactions and keeping track of expenses and revenues is
turn this data into meaning financial information by presenting it in the form of a balance
sheet, income statement, statement of owner's equity, and statement of cash flows.

Accounting Cycle Steps (Here is a simplified summary of the steps in a traditional

accounting cycle)
1.
2.
3.
4.
5.
6.
7.
8.
9.

Identify business events, analyze these transactions, and record them as journal entries
Post journal entries to applicable T-accounts or ledger accounts
Prepare an unadjusted trial balance from the general ledger
Analyze the trial balance and make end of period adjusting entries
Post adjusting journal entries and prepare the adjusted trial balance
Use the adjusted trial balance to prepare financial statements
Close all temporary income statement accounts with closing entries
Prepare the post-closing trial balance for the next accounting period
Prepare reversing entries to cancel temporary adjusting entries if applicable

Flow Chart
After this cycle is complete, it starts over at the beginning. Here is an accounting cycle flow
chart.

1. Journal Entries
Journal entries are the first step in the accounting cycle and are used to record all
business transactions and events in the accounting system. As business events occur
throughout the accounting period, journal entries are recorded in the general journal to
show how the event changed in the accounting equation.
There are generally three steps to making a journal entry
1. Identify Transactions
The business transaction has to be identified. Obviously, if you don't know
a transaction occurred, you can't record one.
2. Analyze Transactions
After an event is identified to have an economic impact on the accounting
equation, the business event must be analyzed to see how the transaction
changed the accounting equation.
When the company purchased the vehicle, it spent cash and received a
vehicle. Both of these accounts are asset accounts, so the overall
accounting equation didn't change. Total assets increased and decreased
by the same amount, but an economic transaction still took place because
the cash was essentially transferred into a vehicle.
3. Journalizing Transactions
After the business event is identified and analyzed, it can be recorded.
Journal entries use debits and credits to record the changes of the
accounting equation in the general journal.
Traditional journal entry format dictates that debited accounts are listed
before credited accounts. Each journal entry is also accompanied by the
transaction date, title, and description of the event.
Example
We are following Paul around for the first year as he starts his guitar store
called Paul's Guitar Shop, Inc. Here are the events that take place.
Journal Entry 1 -- Paul forms the corporation by purchasing 10,000 shares of
$1 par stock.

Journal Entry 2 -- Paul finds a nice retail storefront in the local mall and signs
a lease for $500 a month.

Journal Entry 3 -- PGS takes out a bank loan to renovate the new store
location for $100,000 and agrees to pay $1,000 a month. He spends all of the
money on improving and updating the store's fixtures and looks.

Journal Entry 4 -- PGS purchases $50,000 worth of inventory to sell to

customers on account with its vendors. He agrees to pay $1,000 a month.

Journal Entry 5 -- PGS's first rent payment is due.

Journal Entry 6 -- PGS has a grand opening and makes it first sale. It sells a
guitar for $500 that cost $100.

Journal Entry 7 -- PGS sells another guitar to a customer on account for $300.
The cost of this guitar was $100.

Journal Entry 8 -- PGS pays electric bill for $200.

Journal Entry 9 -- PGS purchases supplies to use around the store.

Journal Entry 10 -- Paul is getting so busy that he decides to hire an employee

for $500 a week. Pay makes his first payroll payment.

Journal Entry 11 -- PGS's first vendor inventory payment is due of $1,000.

Journal Entry 12 -- Paul starts giving guitar lessons and receives $2,000 in
lesson income.

Journal Entry 13 -- PGS's first bank loan payment is due.

Journal Entry 14 -- PGS has more cash sales of $25,000 with cost of goods of
$10,000.

Journal Entry 15 -- In lieu of paying himself, Paul decides to declare a $1,000

dividend for the year.

Now that these transactions are recorded in their journals, they must be
posted to the T-accounts or ledger accounts in the next step of
the accounting cycle.
2. Post Journal Entries to T-Accounts or Ledger Accounts
Once journal entries are made in the general journal or subsidiary journals, they must
be posted and transferred to the T-accounts or ledger accounts.
The purpose of journalizing is to record the change in the accounting equation caused
by a business event. Ledger accounts categorize these changes or debits and credits
into specific accounts, so management can have useful information for budgeting and
performance purposes.

T-Account

Ledger accounts use the T-account format to display the balances in each account.
Each journal entry is transferred from the general journal to the corresponding Taccount. The debits are always transferred to the left side and the credits are
always transferred to the right side of T-accounts.

As a refresher of the accounting equation, all asset accounts have debit balances
and liability and equity accounts have credit balances. All contra accounts have
opposite balances.

Example
Let's post the journal entries that Paul's Guitar Shop, Inc. made during the first year in
business to the ledger accounts.

As you can see, all of the journal entries are posted to their respective T-accounts and
the account balances are calculated on the bottom of each ledger account.

3. Unadjusted Trial Balance

An unadjusted trial balance is a listing of all the business accounts that are going to
appear on the financial statements before year-end adjusting journal entries are made.
That is why this trial balance is called unadjusted.
Format

An unadjusted trial balance is displayed in three columns: a column for account

names, debits, and credits. Accounts with debit balances are listed in the left
column and accounts with credit balances are listed on the right.
Accounts are usually listed in order of their account number. Most charts of
accounts are numbered in balance sheet order, so the unadjusted trial balance also
displays the account numbers in balance sheet order starting with the assets,
liabilities, and equity accounts and ending with income and expense accounts.
As with all financial reports, trial balances are always prepared with a heading.
Typically, the heading consists of three lines containing the company name, name of
the trial balance, and date of the reporting period.

Preparation
Posting accounts to the unadjusted trial balance is quite simple. Basically, each one of the
account balances is transferred from the ledger accounts to the trial balance. All accounts
with debit balances are listed on the left column and all accounts with credit balances are
listed on the right column. That's all there is to it.

Example
After Paul's Guitar Shop, Inc. records its journal entries and posts them to ledger accounts,
it prepares this unadjusted trial balance.

As you can see, all the accounts are listed with their account numbers with corresponding
balances. In accordance with double entry accounting, both of the debit and credit
columns are equal to each other.
Managers and accountants can use this trial balance to easily assess accounts that must
be adjusted or changed before the financial statements are prepared.
After the accounts are analyzed, the trial balance can be posted to the accounting
worksheet and adjusting journal entries can be prepared.
4. Adjusting Entries
Adjusting entries, also called adjusting journal entries, are journal entries made at the
end of a period to correct accounts before the financial statements are prepared.
Adjusting entries are most commonly used in accordance with the matching principle to
match revenue and expenses in the period in which they occur.

Adjusting Entry Types

There are three different types of adjusting journal entries. Each one adjusts income
or expenses to match the current period. This concept is based on the time period
principle which states that accounting records and activities can be divided into
separate time periods. In other words, we are dividing income and expenses into
the amounts that were used in the current period and deferring the amounts that
are going to be used in future periods.

AJEs are used to record:

Prepaid expenses or unearned revenues Prepaid expenses are goods or services
that have been paid for by a company but have not been consumed yet. Insurance is a
good example of a prepaid expense. Insurance is usually prepaid at least six months. This
means the company pays for the insurance but doesn't actually get the full benefit of the
insurance contract until the end of the six-month period. This transaction is recorded as a
prepayment until the expenses are incurred.

Accrued expenses and accrued revenues Many times companies will incur expenses
but won't have to pay for them until the next month. Utility bills are a good example.
December's electric bill is always due in January. Since the expense was incurred in
December, it must be recorded in December regardless of whether it was paid or not. In
this sense, the expense is accrued or shown as a liability in December until it is paid.

Non-cash expenses Adjusting journal entries are also used to record paper expenses
like depreciation, amortization, and depletion. These expenses are often recorded at the
end of period because they are usually calculated on a period basis. For example,
depreciation is usually calculated on an annual basis. Thus, it is recorded at the end of the
year. This also relates to the matching principle where the assets are used during the year
and written off after they are used.

Recording AJEs
Recording adjusting journal entries is quite simple. The process includes three main steps:
Determine current account balance
Determine what current balance should be
Record adjusting entry

These adjustments are then made in journals and carried over to the account ledgers and
accounting worksheet in the next accounting cycle step.

Example
Following our year-end example of Paul's Guitar Shop, Inc., we can see that his unadjusted
trial balance needs to be adjusted for the following events.

-- Paul pays his $1,000 January rent in December.

-- Paul's December electric bill was $200 and is due January 15th.

-- Paul's leasehold improvement depreciation is $2,000 for the year.

-- On December 31, a customer prepays Paul for guitar lessons for the next 6 months.

-- Paul's employee works half a pay period, so Paul accrues $500 of wages.

Now that all of Paul's AJEs are made in his accounting system, he can record them on the
accounting worksheet and prepare an adjusted trial balance.

5. Adjusted Trial Balance

An adjusted trial balance is a listing of all company accounts that will appear on the
financial statements after year-end adjusting journal entries have been made.

Preparing an adjusted trial balance is the fifth step in the accounting cycle and is the
last step before financial statements can be produced.

Format

An adjusted trial balance is formatted exactly like an unadjusted trial balance. Three
columns are used to display the account names, debits, and credits with the debit
balances listed in the left column and the credit balances are listed on the right.

Like the unadjusted trial balance, the adjusted trial balance accounts are usually listed
in order of their account number or in balance sheet order starting with the assets,
liabilities, and equity accounts and ending with income and expense
accounts.

Preparation
There are two main ways to prepare an adjusted trial balance. Both ways are useful
depending on the site of the company and chart of accounts being used.
1. Post accounts to the adjusted trial balance using the same method used in creating the
unadjusted trial balance. The account balances are taken from the T-accounts or ledger
accounts and listed on the trial balance. Essentially, you are just repeating this process
again except now the ledger accounts include the year-end adjusting entries.
2. Take the unadjusted trial balance and simply add the adjustments to the accounts that
have been changed. In many ways this is faster for smaller companies because very
few accounts will need to be altered.
Note that only active accounts that will appear on the financial statements must to be
listed on the trial balance. If an account has a zero balance, there is no need to list it on
the trial balance.
Example
Using Paul's unadjusted trial balance and his adjusted journal entries, we can prepare the
adjusted trial balance.

Once all the accounts are posted, you have to check to see whether it is in balance.
Remember that all trial balances' debit and credits must equal.
Now that the trial balance is made, it can be posted to the accounting worksheet and the
financial statements can be prepared.
Financial Statement Preparation

Preparing general-purpose financial statements; including the balance sheet, income

statement, statement of retained earnings, and statement of cash flows; is the most
important step in the accounting cycle because it represents the purpose of financial
accounting.

In other words, the concept financial reporting and the process of the accounting cycle are
focused on providing external users with useful information in the form of financial
statements.

These statements are the end product of the accounting system in any company.
Basically, preparing these statements is what financial accounting is all about.

Logical order for their preparation:

1.
2.
3.
4.

Income statement
Statement of retained earnings
Balance sheet
Cash flow statement

Income Statement

The income statement reports revenues, expenses, and the resulting net
income. It is prepared by transferring the following ledger account balances,
taking into account any adjusting entries that have been or will be made:
Revenue
Expenses
Capital gains or losses Statement of Retained Earnings

Statement of Retained Earnings

The retained earnings statement shows the retained earnings at the beginning
and end of the accounting period. It is prepared using the following information:
Beginning retained earnings, obtained from the previous statement of
retained earnings.
Net income, obtained from the income statement
Dividends paid during the accounting period Balance Sheet

Balance Sheet

The balance sheet reports the assets, liabilities, and shareholder equity of the
company. It is constructed using the following information:

Balances of all asset accounts such cash, accounts receivable, etc.

Balances of all liability accounts such as accounts payable, notes, etc.
Capital stock balance
Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

The cash flow statement explains the reasons for changes in the cash balance,
showing sources and uses of cash in the operating, financing, and investing
activities of the firm. Because the cash flow statement is a cash-basis report, it
cannot be derived directly from the ledger account balances of an accrual
accounting system. Rather, it is derived by converting the accrual information to
a cash-basis using one of the following two methods:
1. Direct method
Cash flow information is derived by directly subtracting cash
disbursements from cash receipts.
2. Indirect method
Cash flow information is derived by adding or subtracting non-cash
items from net income. Income Statement

Preparation

Preparing general-purpose financial statements can be simple or complex depending on

the size of the company. Some statements need footnote disclosures while other can be
presented without any. Details like this generally depend on the purpose of the financial
statements.

Financial statements are prepared by transferring the account balances on the adjusted
trial balance to a set of financial statement templates.

Accounting Worksheet

An accounting worksheet is a tool used to help bookkeepers and accountants complete the
accounting cycle and prepare year-end reports like unadjusted trial balances, adjusting
journal entries, adjusted trial balances, and financial statements.

Format

The accounting worksheet is essentially a spreadsheet that tracks each step of the
accounting cycle.

The spreadsheet typically has five sets of columns that start with the unadjusted trial
balance accounts and end with the financial statements.
In other words, an accounting worksheet is basically a spreadsheet that shows all of the
major steps in the accounting cycle side by side.

Example
Here is what Paul's Guitar Shop's year-end would look like in accounting worksheet format for
the accounting cycle examples in this section.

As you can see, the worksheet lists all the trial balances and adjustments side by side.
During the accounting cycle process, an accounting worksheet can be helpful to keep
track of the different steps and reduce errors.

It can also be used for an analytical and summary tool to show how accounts were
originally posted to the ledger and what adjustments were made before they were
presented on the financial statements.

Closing Entries

Closing entries, also called closing journal entries, are entries made at the end of an
accounting period to zero out all temporary accounts and transfer their balances to
permanent accounts.
In other words, the temporary accounts are closed or reset at the end of the year. This is
commonly referred to as closing the books.

Temporary accounts

These are income statement accounts that are used to track accounting activity during
an accounting period. For example, the revenues account records the amount of
revenues earned during an accounting periodnot during the life of the company. We
don't want the 2015 revenue account to show 2014 revenue numbers.

Permanent accounts

These are balance sheet accounts that track the activities that last longer than an
accounting period. For example, a vehicle account is a fixed asset account that is
recorded on the balance. The vehicle will provide benefits for the company in future
years, so it is considered a permanent account.

At the end of the year, all the temporary accounts must be closed or reset, so the beginning of
the following year will have a clean balance to start with. In other words, revenue, expense, and
withdrawal accounts always have a zero balance at the start of the year because they are always
closed at the end of the previous year. This concept is consistent with the matching principle.

Closing Entry Types

Temporary accounts can either be closed directly to the retained earnings account or to
an intermediate account called the income summary account. The income summary
account is then closed to the retained earnings account. Both ways have their
advantages.

Closing all temporary accounts to the income summary account leaves an audit trail for
accountants to follow. The total of the income summary account after the all temporary
accounts have been close should be equal to the net income for the period.

Closing all temporary accounts to the retained earnings account is faster than using the
income summary account method because it saves a step. There is no need to close
temporary accounts to another temporary account (income summary account) in order
to then close that again.

Both closing entries are acceptable and both result in the same outcome. All temporary accounts
eventually get closed to retained earnings and are presented on the balance sheet.

There are three general closing entries that must be made.

1. Close all revenue and gain accounts
All of Paul's revenue or income accounts are debited and credited to the income summary
account. This resets the income accounts to zero and prepares them for the next year.

Remember that all revenue, sales, income, and gain accounts are closed in this entry. Paul's
business or has a few accounts to close.
2. Close all expense and loss accounts
All expense accounts are then closed to the income summary account by crediting the expense
accounts and debiting income summary.

3. Close all dividend or withdrawal accounts

Since dividend and withdrawal accounts are not income statement accounts, they do not
typically use the income summary account. These accounts are closed directly to retained
earnings by recording a credit to the dividend account and a debit to retained earnings.
Now that all the temporary accounts are closed, the income summary account should have a
balance equal to the net income shown on Paul's income statement. Now Paul must close the
income summary account to retained earnings in the next step of the closing entries.

Income Summary Account

The income summary account is a temporary account used to store income statement
account balances, revenue and expense accounts, during the closing entry step of the
accounting cycle.

In other words, the income summary account is simply a placeholder for account balances
at the end of the accounting period while closing entries are being made.
Example
After Paul's Guitar Shop prepares its closing entries, the income summary account has a
balance equal to its net income for the year. This balance is then transferred to the
retained earnings account in a journal entry like this.

After this entry is made, all temporary accounts, including the income summary account,
should have a zero balance.
Now that Paul's books are completely closed for the year, he can prepare the post-closing
trial balance and reopen his books with reversing entries in the next steps of
the accounting cycle.
Post-Closing Trial Balance

The post-closing trial balance is a list of all accounts and their balances after the closing
entries have been journalized and posted to the ledger.
In other words, the post-closing trial balance is a list of accounts or permanent accounts
that still have balances after the closing entries have been made.

This accounts list is identical to the accounts presented on the balance sheet. This makes
sense because all of the income statement accounts have been closed and no longer have
a current balance.

The purpose of preparing the post-closing trial balance is to verify that all temporary
accounts have been closed properly and the total debits and credits in the accounting
system equal after the closing entries have been made.

Format

A post-closing trial balance is formatted the same as the other trial balances in the
accounting cycle displaying in three columns: a column for account names, debits, and
credits.
Since only balance sheet accounts are listed on this trial balance, they are presented in
balance sheet order starting with assets, liabilities, and ending with equity.

Preparation

Posting accounts to the post-closing trial balance follows the exact same procedures as
preparing the other trial balances. Each account balance is transferred from the ledger
accounts to the trial balance. All accounts with debit balances are listed on the left
column and all accounts with credit balances are listed on the right column.
The process is the same as the previous trial balances. Now the ledger accounts just
have post-closing entry totals.

Example
After Paul's Guitar Shop posted its closing journal entries in the previous example, it
can prepare this post-closing trial balance.

Notice that this trial balance looks almost exactly like the Paul's balance sheet except
in trial balance format. This is because only balance sheet accounts are have balances
after closing entries have been made.

Now that the post-closing trial balance is prepared and checked for errors, Paul can
start recording any necessary reversing entries before the start of the next accounting
period.

Reversing Entries

Reversing entries, or reversing journal entries, are journal entries made at the beginning of
an accounting period to reverse or cancel out adjusting journal entries made at the end of
the previous accounting period.

This is the last step in the accounting cycle.

Reversing entries are made because previous year accruals and prepayments will be paid
off or used during the New Year and no longer need to be recorded as liabilities and assets.
These entries are optional depending on whether or not there are adjusting journal entries
that need to be reversed.

Reversing entries are usually made to simplify bookkeeping in the New Year.

Example
It might be helpful to look at the accounting for both situations to see how difficult bookkeeping
can be without recording the reversing entries. Let's look at let's go back to your accounting
cycle example of Paul's Guitar Shop.
In December, Paul accrued $250 of wages payable for the half of his employee's pay period that
was in December but wasn't paid until January. This end of the year adjusting journal entry
looked like this:

Accounting with the reversing entry:

Paul can reverse this wages accrual entry by debiting the wages payable account and crediting
the wages expense account. This effectively cancels out the previous entry.

But wait, didn't we zero out the wages expense account in last year's closing entries? Yes, we
did. This reversing entry actually puts a negative balance in the expense. You'll see why in a
second.
On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then record
the payment by debiting the wages expense account for $500 and crediting the cash account for
the same amount.

Since the expense account had a negative balance of $250 in it from our reversing entry, the
$500 payment entry will bring the balance up to positive $250-- in other words, the half of the
wages that were incurred in January.

See how easy that is? Once the reversing entry is made, you can simply record the payment
entry just like any other payment entry.
Accounting without the reversing entry:
If Paul does not reverse last year's accrual, he must keep track of the adjusting journal entry
when it comes time to make his payments. Since half of the wages were expensed in December,
Paul should only expense half of them in January.
On January 7th, Paul pays his employee $500 for the two week pay period. He would debit wages
expense for $250, debit wages payable for $250, and credit cash for $500.

The net effect of both journal entries have the same overall effect. Cash is decreased by $250.
Wages payable is zeroed out and wages expense is increased by $250. Making the reversing
entry at the beginning of the period just allows the accountant to forget about the adjusting
journal entries made in the prior year and go on accounting for the current year like normal.

As you can see from the T-Accounts above, both accounting method result in the same balances.
The left set of T-Accounts are the accounting entries made with the reversing entry and the right
T-Accounts are the entries made without the reversing entry.

Recording reversing entries is the final step in the accounting cycle. After these entries are
made, the accountant can start the cycle over again with recording journal entries. This cycle
repeats in the exact same format throughout the current year.