This article discusses the accounting cycle.
Account balances sitting in general ledger “T” accounts do not provide a very useful format for accessing accounting information. Periodically, accountants need to compile the information in the general ledger into the basic financial statements: the balance sheet and income statement. How often should this happen? From a manager’s point of view, basic financial statements should be prepared in a timely fashion so any unexpected trends in revenues and expenses can be detected and addressed. Most businesses find monthly statements adequate, although firms operating under very stable economic conditions find quarterly or annual financial statements sufficient.
Compiling and preparing financial statements usually necessitates making adjustments to general ledger account balances. Adjustments? Why do we need adjustments? Why can’t the accountants get it right the first time? No matter how diligent and efficient the accountants, adjustments will be needed to correct certain account balances.
For example, it is customary to analyze accounts receivable to determine if individual outstanding accounts are actually collectable. Any accounts deemed uncollectable are written off, and this requires an adjustment.
Accounts involving fixed assets and depreciation almost always require some adjustment. Most firms record depreciation expense based on the assets on hand at the beginning of the period. These entries are not changed each month to reflect new asset additions or asset retirements.
If a business maintains ending inventory, the balance recorded in the general ledger account must be reconciled with the actual physical count of inventory on hand at the end of the period.
Finally, all other accrual accounts involving prepaids and deferrals also need to be analyzed and perhaps adjusted.
Aggregating account balances on a worksheet called a trial balance facilitates the adjustment process. An example of a trial balance follows. The first column of this worksheet is simply a list of all general ledger accounts, starting with the balance sheet accounts and ending with the income statement accounts. The next column (or two columns if there are separate columns for debit and credit) shows the account balances before adjustments.
Adjusting entries follow the same debit/credit form used for recording transactions during the year. The entries themselves are first recorded in a general journal and then posted to the appropriate general ledger account. Unlike other recorded transactions, these adjusting entries are also posted on the trial balance. These entries usually involve standard pairings of balance sheet and income statement accounts. For example, an adjustment to Accounts Receivable almost always requires an offsetting adjustment to a Revenue or Sales account. Here is a list of typical account pairings found in adjustment entries:
Adjustments very often go in both directions. The balance sheet accounts may require increases or decreases, so the corresponding income statement accounts also must increase or decrease in offsetting fashion. In making adjusting entries, you might need to debit a revenue account, or credit an expense account, even though you would rarely if ever see this pattern in recording ordinary transactions. In the adjustment process, it is not unusual for the same account to require more than one adjustment, with the adjustments made in opposite directions. One adjusting entry can increase a revenue account, and another adjusting entry can decrease the same revenue account.
Example. In analyzing the account balances for Joint Ventures at the end of the most recent accounting period, the bookkeeper has discovered that the following accounts need adjustment:
a.Because of fixed asset additions during the year, it was determined that depreciation expense was understated by $2,081.
b.An analysis of the deferred revenue account indicated that the account was overstated by $1,500.
c.A $350 payment of interest on a loan was incorrectly recorded as a principalrepayment.
d.In reconciling the checking account, it was determined that $24 of bank service charges had not been recorded.
The journal entries reflecting these adjustments are as follows:
After the adjusting entries are posted in the middle columns of the trial balance, the account balances are extended across to the next column, the adjusted balance column. The final columns on the right of the trial balance are used to construct the basic financial statements: the balance sheet and the income statement.
The final step in the year-end adjustment process is the preparation of closing entries that bring the income statement accounts to zero. Why is this needed? Generally, businesses want to track balances in these accounts for one year at a time. It would not do for current year revenues and expenses to be aggregated with prior year amounts. So, at the beginning of each new accounting period, the income and expense balances should be zero. This means that the aggregate balances from the prior period have to be eliminated. How do we eliminate an entire period’s worth of balances in these accounts?
Recall that income and expense accounts are sub-categories of the equity section of the balance sheet. A sub-account of the equity category called Prior Year Income or Retained Earnings is used to transfer all year end income and expense account balances. In the case of sole proprietorships these account balances are closed directly to the Owner’s Equity account.
Example. Based upon the final adjusted income statement account balances shown in the last columns of the trial balance, Joint Ventures’ closing entry would be as follows:
Remember: asset, liability and equity accounts are never closed. These balances are carried from period to period.