U U N IT

3
Financial Accounting Cycle
(Part II)

Overview

In Unit 2 you were shown how accounting is actually done in a business to include
journalizing of transactions, posting of transactions to the general ledger, then finally
the extraction of a trial balance at the end of the period. In this unit you will review the
adjusting process and exposed to the cash and accrual basis of accounting. The unit
provides examples of adjusting entries for prepaid rent, supplies, and depreciation
of furniture. Accumulated depreciation and book value are explained. The unit then
provides examples and discusses accrued salaries, accrued service revenue, and
unearned service revenue. A comparison of the timing of both prepaid and accruals
along with a summary of the adjusting process concludes the discussion of adjusting
entries. You will be given the opportunity to prepare an adjusted trial balance and
then use it to prepare the financial statements. The unit concludes with an explanation
of the processes involved in completing the accounting cycle.

24  © 2015 University of the West Indies Open Campus

Learning Objectives

After reading the unit and completing the learning activities, you will be able to:

1. Differentiate between accrual and cash-basis accounting

2. Define and apply the accounting period concept, revenue recognition and
matching principles, and time period concept

3. Explain why adjusting entries are needed

4. Journalize and post adjusting entries

5. Explain the purpose of and prepare an adjusted trial balance

6. Prepare the financial statements from the adjusted trial balance

7. Apply the alternate treatment of unearned revenues and prepaid expenses

This unit comprises two sessions as follows:

Session 3.1: Adjusting the Books

Session 3.2: Completing the Financial Accounting Cycle

Readings & Resources

Horngren, C. T., Harrison, W. T., & Oliver, S. M. (2009). Accounting (8th ed.). Upper
Saddle River, NJ: Prentice Hall.

The Pros and Cons of Cash-Basis and Accrual Accounting. Retrieved from
http://zapt.io/tbayzamd

ACCT1002 Introduction to Financial Accounting – UNIT 3  25

 SSession 3.1

Adjusting the Books

Introduction
Accountants have several accounting principles or concepts that guide them in
recording financial information. Some of the principles, in addition to accrual
accounting versus cash-basis accounting, include the accounting period concept and
the revenue principle.

In this session we will discuss the accrual vs. cash basis accounting, and explain
their associated accounting concepts. The five categories of adjusting entries prepaid
expenses, depreciation, accrued expenses, accrued revenues, and unearned revenues
will also be addressed in this unit. Students will learn how to prepare the adjusted
trial balance based on adjusting entries made and thereafter they will learn how to
prepare the financial statements.

Learning Objectives
On completion of this session you will be able to:

1. Differentiate between accrual and cash-basis accounting

2. Define and apply the accounting period concept, revenue recognition and
matching principles, and time period concept

3. Explain why adjusting entries are needed

4. Journalize and post adjusting entries

5. Explain the purpose of and prepare an adjusted trial balance and financial
statements.

Why Accrual Accounting or Cash-Basis Accounting?

Before you can start recording business transactions, you must decide whether to use
cash-basis or accrual accounting. The main difference between these two accounting
processes is in how you record your cash transactions. With cash-basis accounting, you
record all transactions in the books when cash actually changes hands, meaning when
cash payment is received by the company from customers or paid out by the company

26  ACCT1002 Introduction to Financial Accounting – UNIT 3

for purchases or other services. Cash receipt or payment can be in the form of cash,
check, credit card, electronic transfer, or other means used to pay for an item. With
the cash-basis accounting method, the owner only records the purchase of supplies or
goods that will later be sold when he actually pays cash. If he buys goods on credit to
be paid later, he doesn’t record the transaction until the cash is actually paid out.

In the case of accrual accounting, you record all transactions in the books when they
occur, even if no cash changes hands. For example, if you sell on store credit, you
record the transaction immediately and enter it into an Accounts Receivable account
until you receive payment. If you buy goods on credit, you immediately enter the
transaction into an Accounts Payable account until you pay out cash.

Play Video
The Pros and Cons of Cash-Basis and Accrual Accounting:

uuhttp://zapt.io/tbayzamd

Horngren, Harrison and Oliver (2009 p. 134 to 135) illustrates the impact of some
transactions on both accrual account and cash-basis accounting.


LEARNING ACTIVITY 3.1

1. Compare and contrast the distinctive features of accrual accounting
and cash basis accounting. Your response should be no more than
one page or no more than 200 words. Download this compare and
contrast worksheet to organise your thoughts for this activity.

uuhttp://media.open.uwi.edu/ACCT1002/u3/CCWorksheet.pdf
2. Post your response in the Students-Tutor Exchange forum and
respond critically to at least one of your peers.

Why Other Accounting Principles and Concepts?

By now you should recognize that accountants have several accounting principles or
concepts that guide them in recording financial information. Some of the principles,
in addition to accrual accounting versus cash-basis accounting, include the accounting
period concept, the revenue principle, the matching principle, and the time period
concept.

ACCT1002 Introduction to Financial Accounting – UNIT 3  27

 You should for example know when various types of businesses’ fiscal year might end
as these form the basis of the concept of accounting periods. The revenue principle is
important for your understanding of adjusting entries related to revenue recognition.
In principle you cannot anticipate revenue and can only record it only when it has
materialized. In the case of the matching principle, expenses are to be matched against
the revenues to which they relate. For example, the Open Campus will match your
tuition fees (an income to them) paid by you during the semester against the cost it
incurs to pay its lecturers for the same semester. Horngren et al (2009), gives you a
close up look at these other accounting principles on pages 135 to 138 and you should
carefully note and understand how these are applied within accounting.

LEARNING ACTIVITY 3.2

Reflection
1. Critically reflect on how the matching principle relates to the
revenue principle. Your response should be no more than one page
or no more than 200 words.

2. Post your response in the Student-Tutor Exchange forum and

respond critically to at least one of your peers.

Why We Adjust the Accounts?

LEARNING ACTIVITY 3.3

Test Your Understanding
To test your own understanding of the above question please click on
the link provided and read through each scenario given and answer
the question below each.

uuhttp://media.open.uwi.edu/ACCT1002/u3/mc1/index.htm

We make adjusting entries to update the accounts prior to the preparation of the
financial statements as the trial balance may not include certain revenue and expense
transactions which may have been omitted during the accounting period. Adjusting
entries are done to allocate revenues and expenses among accounting periods in

28  ACCT1002 Introduction to Financial Accounting – UNIT 3

accordance with the realization and matching principles. Every adjusting entry
involves the recognition of either revenue or expenses, and affects both the income
statement (revenue and expenses) and the balance sheet (assets & liabilities)

Types of Adjusting Entries

1. Prepaid Expenses
Advance payments of expenses or cash paid for services not yet used up e.g. rent,
insurance and electricity.

• When payment is made: Debit Prepaid Expense A/C and Credit Cash

• When expense is incurred: Debit Expense A/C and Credit Prepaid Expense

Prepaid expenses are listed among current assets in the balance sheet. In the text,
Horngren et al (2009), two different examples of a prepaid expense are illustrated
from pages 139 through to 141. In the first case you are shown the entries relating to
prepaid rent expense while in the other you are shown how supplies are accounted
for as prepaid expenses.

2. Depreciation
Depreciation may be defined as the spread of the cost of a fixed asset over its economic
useful life or the fall in the value of a fixed asset. Depreciation may come about as a
result of general wear and tear, changes in technology and/or obsolescence. Land is
the only fixed asset, which is deemed to be not depreciable. The cost of a fixed asset
should be written off over its economic useful life. This is in accordance with the
accruals or matching concept. Thus, the part of the cost of the fixed asset consumed in
earning the income for a period is an expense and must be taken out of profits.

In determining depreciation the accountant must know

1. The capitalized cost of the fixed asset

2. The assets economic useful life

3. The residual value of the fixed asset i.e. book value at the end of economic
useful life.

The physical life of an asset is different from its economic life. The physical life is
the period, over which the asset will remain intact, while the economic life is the
period over which the asset can be used by the business to assist in earning its income.
This may be influenced by technological advancement. There are several methods of
depreciation and the most commonly used method is the straight-line method. This
method assumes that the fixed asset is depreciated by the same amount every year.

Horngren et al (2009 p. 142) illustrates the computation of the depreciation charge

in the example used. Here, you will see that in using the straight line method the
depreciation charge amounts to $300 (cost $3,600/years 12). To record the deprecation

ACCT1002 Introduction to Financial Accounting – UNIT 3  29

 charge in this example and as a general rule we debit depreciation expense and credit
accumulated depreciation.

On page 143 of the same text, Horngren et al also illustrates the balance sheet extract
depicting the presentation required for the fixed asset. Please note that depreciation
expense will appear in the income statement with the other expenses while Accumulated
depreciation will be reflected in the balance sheet as a deduction from the cost of the
fixed asset (referred to as the net book value).

3. Accrued Expenses
Accrued expenses are amounts owing for an expense, at the end of an accounting
period, or it may be viewed as an expense the business has incurred but not yet paid.
To record Debit Expense A/C; Credit Expense Payable e.g. Rent Payable. Accrued
expenses are shown in the balance sheet under the heading current liabilities. Please
go to pages 145 -146 of the text where you will find two examples of accrued expenses
and the accounting entries involved in both cases.

4. Accrued revenue
Accrued revenues are income earned during the accounting period but not yet received
or collected. To record Debit Account/Revenue Receivable A/C, Credit Revenue
Earned A/C. Accrued revenue or revenue receivable is reflected in the balance sheet
as a current asset. In your text, Horngren et al. (2009 p. 146) illustrates an example
of the accounting treatment for the accrued income earned by Smart Touch Learning.

5. Unearned revenues
Horngren et al. (2009 p. 147) shows an example of the accounting treatment relating
to unearned revenues and you will note that unearned revenues or deferred revenues
are payments or cash received by a company in the current period in respect of future
sales or service. Unearned income as it is sometimes called, represents a liability to
the business and at the end of the accounting period, it is reflected in the balance sheet
under currently liability.

LEARNING ACTIVITY 3.4

Test Your Understanding
Using the link provided do the interactive quiz to see how much you
have learnt so far about Adjusting Accounts

uuhttp://media.open.uwi.edu/ACCT1002/u3/mc2/index.htm

30  ACCT1002 Introduction to Financial Accounting – UNIT 3

Before attempting the following Learning Activity you should closely review the
summary problem and solution from pages 157–161 in Horngren et al. (2009). This
exercise is also expected to prepare you to move onto the next level in the accounting
cycle.

LEARNING ACTIVITY 3.5

Posting from Journal to General Ledger
1. Prepare the journal entries for the following transactions provided
by MPM as at January 31, 2011 and post them to their respective
general ledger accounts.

a. Depreciation $100

b. Prepaid rent expired $400

c. Interest expense accrued $900

d. Employee salaries owed for Monday to Thursday for a five day

workweek: weekly payroll $14,000

e. Unearned service revenue $800

2. Post your response in the Student-Tutor Exchange forum and

respond critically to at least one of your peers.

Why Prepare an Adjusted Trail Balance?

As already mentioned, the first trial balance that is extracted from the general ledger
at the end of the accounting period is referred to as the unadjusted trial balance. After
this point, adjustments are journalized and a second trial balance, referred to as the
adjusted trial balance, is prepared and is used to prepare the financial statements.

Exhibit 3-9, on page 152 of Horngren et al. (2009) shows a worksheet depicting the
unadjusted trial balance, followed by the adjustments made to the affected accounts
then the adjusted trial balance. Here you will note for example that in the case of
the cash account, the amount in the unadjusted trial balance shows $3,000 with no
adjustment in the adjustments column, resulting in the same balance on the debit side
in the adjusted trial balance column. The situation is different however in the case
of accounts receivable which shows $2,200 as a debit balance in the unadjusted trial
balance. This was followed by a debit adjusting entry in the adjustments column then
a debit balance of $2,600 in the adjusted trial balance column. You must review all the
other accounts within this exhibit to grasp a full understanding of the preparation of

ACCT1002 Introduction to Financial Accounting – UNIT 3  31

 the adjusted trial balance which as mentioned before, is what will be used to prepare
the financial statements.

LEARNING ACTIVITY 3.6

Completing the Adjusted Trial Balance
Shining Image Company, the cleaning service, started the preparation
of its adjusted trail balance as follows: Please review carefully and
answer the question below.
Shining Image Company
Adjusted Trial Balance
December 31, 2010

Trial Balance
Account Debit Credit
Cash 1,100
Supplies 2,000
Prepaid insurance 600
Equipment 30,000
Accumulated Depreciation-Equipment 2,000
Accounts payable 1,700
Salary payable
Unearned service revenue 400
Roberta Defuniak, Capital 15,600
Roberta Defuniak, Withdrawals 1,000
Service revenue 22,000
Salary expense 7,000
Supplies expense
Depreciation expense
Insurance expense
Total 41,700 41,700

During the twelve months ended December 31, 2010, Shining Image
did the following:

a. Used supplies of $1,100

b. Used up prepaid insurance of $590
c. Used up $510 of the equipment through depreciation.
d. Accrued salary expense of $270 that Shining Image has not
paid yet.
e. Earned $370 of the unearned service revenue.
Cont’d...

32  ACCT1002 Introduction to Financial Accounting – UNIT 3

 Learning Activity 3.6 ...Cont’d

1. Complete the adjusted trial balance above (see Horngren et al.

(2009) p. 152).

2. Post your response in the Tutor Student Exchange forum and

respond critically to at least one of your peers.

Why Prepare the Financial Statements?

The information relating to a business is usually communicated by way of financial
statements and these are usually analyzed to evaluate the performance or financial
status of the business. The financial statements include:

1. Income statement

2. Statement of changes in owner’s equity

3. Balance sheet

The Income Statement

Also called Statement of Profit or Loss and other comprehensive income is a summary
of all the revenues (income from sale of goods or services) a company earns minus
all the expenses incurred in earning the revenues, for a specific period – a month, a
quarter or a year. The Income statement is therefore regarded as an activity statement.
The statement tells whether the business earned a net income, i.e., total revenues >
total expenses or a net loss i.e. total expenses > total revenues.

Exhibit 3-10, in Horngren et al. (2009 p. 154) shows the income statement for Smart
Touch Learning based on the question introduced earlier in the text. Here you should
observe that the service revenue amounted to $7,600 while the total expenses amounted
to $3,900. The difference of $3,700 represents a net income or profit for the company.

The Statement of Owner’s Equity

The statement of owner’s equity also called statement of changes in equity shows the
movement in the equity of the balance sheet or statement of financial position.

Note that Exhibit, 3-11, in Horngren et al. (2009 p. 154) shows the statement of owner’s
equity for the company. Here you should note too that the statement commences with
the opening capital, plus net income, less drawings (owner withdrawals) to yield the
closing or adjusted capital.

ACCT1002 Introduction to Financial Accounting – UNIT 3  33

 The Balance Sheet
The balance sheet, also referred to as Statement of Financial Position, describes the
financial position of the business at a specific point in time. It is a position statement,
which gives a snap shot of the business at a point in time.

Exhibit, 3-12, in Horngren et al. (2009 p. 154) illustrates the balance sheet for Soft
Touch Learning. It is important to note firstly that only assets, liabilities and capital
are reflected in the balance sheet. You ought to observe as well that in the owner’s
equity section it is the ending capital balance that is reflected as extracted from the
statement of owner’s equity. Another important point to note is that the accumulated
depreciation is subtracted from the respective assets and not shown under the liability
section. As a general rule you must subtract the accumulated depreciation from the
fixed assets (example furniture and building) to yield their respective net book value
(NBV).

LEARNING ACTIVITY 3.7

Preparing an Income Statement
1. From the information presented in Activity 3.6 prepare the Income
statement, Statement of Owner’s Equity and Balance Sheet for
Shining Image Company.

2. Post your response in the Discussion forum and respond critically

to at least one of your peers.

Session 3.1 Summary

The session focused on the two ways of doing accounting by reviewing the accrual
accounting versus the cash basis accounting methods. The two categories of adjusting
entries were defined and examples of each type were illustrated. Before moving on to
the final stage of the Accounting Cycle, you should know how to journalize and post
adjusting entries. In this session, we also examined the preparation of the adjusted
trial balance which was then used in the preparation of the financial statements. In the
next session you will examine the accounting processes involved in completing the
accounting cycle.

34  ACCT1002 Introduction to Financial Accounting – UNIT 3

SSession 3.2

Completing the Accounting Cycle

Introduction
In Session 3.1 you went through the adjustment process and the preparation of the
adjusted trial balance. In this session you will complete the accounting cycle which
includes closing the books, the preparation of a more completed version of the adjusted
trial balance through the use of the accounting worksheet and how to prepare the
classified financial statements from the accounting worksheet.

Why the Accounting Worksheet?

The accounting worksheet also called the Accountant’s Worksheet is a columnar form
document, which pulls together all the information needed to enter adjusting entries
and to prepare the financial statements. Worksheets are not financial statements nor
a formal part of the accounting system. It is merely a tool used by the accountant at
the end of the accounting period to assist in the preparation of the financials. The
worksheet is usually prepared in pencil or as a spreadsheet on the computer.

Exhibits, 4-2 through to 4-6, in Horngren et al. (2009 p. 208) illustrates the development
of a typical worksheet and uses the Smart Touch Learning question as a guide to
demonstrate how the process is applied to a real life case.

You should also note the summary problem and solution, Horngren et al. (2009 pp.
211-212) as this should add to your knowledge base to master this area.

Why the Closing Process?

Closing entries reduce all nominal or temporary accounts to zero balances at the end
of the accounting to facilitate preparation of the said accounts for the start of the next
period. The closing process involves the following:

• Close all revenue accounts to the Income Summary.

• Close all expense accounts to the Income Summary.

• Close Income summary to the Owner’s equity A/C.

• Close drawings to the Owner’s Equity/Capital A/C.

ACCT1002 Introduction to Financial Accounting – UNIT 3  35

 Exhibit 4-10, Horngren et al. (2009 p. 217 -218) illustrates the four steps involved in the
closing process and uses the Smart Touch Learning question as used in the previous
session and units to demonstrate how the process is applied to a real life case.

Why the Post-Closing Trial Balance?

The Post-closing trial balance provides a listing of all real/permanent accounts after
the closing entries and assures that total debits equal total credits before the start of
the new accounting period. Only assets, liabilities and capital accounts appears on the
post-closing trial balance as seen in Horngren et al. (2009 p. 219), which shows such
a balance for Smart Touch Learning to complete its accounting cycle for May 2010 .

Why Classify Assets and Liabilities?

Assets and liabilities are classified according to their liquidity into the categories
of current, fixed or long-term. Liquidity is a measure of how quickly these assets
or liabilities can be converted into cash. Assets can be classified as current or fixed
assets. Examples of current assets include cash, accounts receivable, supplies, and
prepaid expenses, while examples of fixed assets includes furniture, and buildings.
Liabilities on the other hand can be classified as current or long term. Examples of
current liabilities include accounts payable, salary payable, interest payable, and
unearned revenues, while examples of long-term liabilities include note payables and
mortgages.

The Classified Balance Sheet

The classified balance sheet is different from the balance sheet illustrated previously
and presents the assets and liabilities within their respective categories as either
current asset, fixed asset, current liabilities, long-term liabilities or owner’s equity.
Exhibit, 4-12 and 4-13, in Horngren et al. (2009, pp. 221-222) illustrates two different
forms for presenting the balance sheet and you should carefully note the distinctive
features of each before moving further.

Before attempting the following Learning Activity you should closely review
summary problem 2 and solution, in Horngren et al. (2009, pp. 225-228).

36  ACCT1002 Introduction to Financial Accounting – UNIT 3

 LEARNING ACTIVITY 3.8
Preparation of Accounting Worksheet, etc.
1. Prepare the accounting worksheet, classified balance sheet,
closing entries, and post-closing trial balance based on the
information provided in Activity 3.6 (Shining Image Company).

2. Post your response in the Student-Tutor Exchange forum and

respond critically to at least one of your peers.

Session 3.2 Summary

In this session we have reviewed the processes to complete the accounting cycle to
include the preparation of the accounting worksheet, the preparation of the closing
entries and the preparation of the classified financials and the post-closing trial balance.

ACCT1002 Introduction to Financial Accounting – UNIT 3  37

 Unit 3 Summary

In this unit you reviewed the adjusting process as well as the cash and accrual basis of
accounting. Examples of adjusting entries for prepaid rent, supplies, and depreciation
of furniture were seen and the accumulated depreciation and book value were
explained. You were given the opportunity to prepare an adjusted trial balance and
then use it to prepare the financial statements. The unit concluded with an explanation
of the processes involved in completing the accounting cycle.

In the next unit you will be shown how to account for the assets of a business and you
will also exposed to the purposes and characteristics of an effective system of internal
control.

References
Horngren, C. T., Harrison, W. T., & Oliver, S. M. (2009). Accounting (8th ed.). Upper
Saddle River, NJ: Prentice Hall.

The Pros and Cons of Cash-Basis and Accrual Accounting. Retrieved from
http://zapt.io/tbayzamd

38  ACCT1002 Introduction to Financial Accounting – UNIT 3