Chapter 2: Review of the Accounting Process
Lecture Notes
● The Accounting Cycle (Steps 1-10):
○ Analyze Transactions: Identify the economic event and its dual
effect on the accounting equation (A=L+E).
○ Journalize Transactions: Record the dual effect (debit/credit) in
the General Journal chronologically.
1. Debit (DR): Left side. Increases A, E, and Rev (or Liab and
Exp).
2. Credit (CR): Right side. Increases L, E, and Rev (or A and
Exp).
○ Post to the Ledger: Transfer the debits and credits from the journal
to the individual T-accounts in the General Ledger.
○ Prepare a Trial Balance: A list of all accounts and their balances at
a specific point in time to ensure TotalDRs=TotalCRs.
○ Journalize and Post Adjusting Entries: Entries made at the end of
the accounting period to bring all accounts (especially Revenue and
Expense) up to date on an accrual basis.
○ Prepare an Adjusted Trial Balance: A new trial balance after
posting all adjusting entries; the source for preparing financial
statements.
○ Prepare Financial Statements: Use the Adjusted Trial Balance data
(Income Statement first, then Statement of Retained Earnings, then
Balance Sheet).
○ Journalize and Post Closing Entries: Entries made to close
temporary accounts (Revenues, Expenses, Dividends/Drawings)
and transfer their balances to a permanent equity account
(Retained Earnings/Capital).
○ Prepare a Post-Closing Trial Balance: Lists only permanent
accounts (A, L, E); confirms that TotalDRs=TotalCRs and temporary
accounts have zero balances.
○ Journalize and Post Reversing Entries (Optional): Used primarily
to simplify the recording of a subsequent period's transactions,
particularly those that were initially established by accrual
adjusting entries.
● Accrual vs. Cash Basis:
○ Accrual Basis (Required by GAAP/IFRS): Revenues are recognized
when the performance obligation is satisfied, and expenses are
recognized when incurred (matching principle), regardless of when
cash is exchanged.
○ Cash Basis: Revenues are recognized when cash is received, and
expenses are recognized when cash is paid. Not GAAP compliant
because it can distort profitability.
● Types of Adjusting Entries (A/E):
○ Deferrals (Cash ↑ First, A/E later):
1. Prepaid Expenses: Costs paid in advance (e.g., rent,
insurance). A/E:Expense DR,Asset CR.
2. Unearned Revenues: Cash received in advance for future
services/goods. A/E:Liability DR,Revenue CR.
○ Accruals (A/E First, Cash ↑ Later):
1. Accrued Revenues: Revenue earned but not yet received in
cash or billed (e.g., services completed). A/E:Asset
DR,Revenue CR.
2. Accrued Expenses: Expenses incurred but not yet paid in
cash or recorded (e.g., salaries, interest). A/E:Expense
DR,Liability CR.
● The Worksheet (Optional Tool):
○ A columnar schedule used to facilitate the orderly preparation of
financial statements; it is not a part of the formal accounting
records.
● Closing Entries:
○ Purpose: To reduce the balance of all temporary (nominal)
accounts to zero and determine the net income/loss for the period.
○ Process (usually 4 steps):
1. Close all Revenue accounts (DR) to Income Summary (CR).
2. Close all Expense accounts (CR) to Income Summary (DR).
3. Close Income Summary (Net Income/Loss) to Retained
Earnings (or Capital).
4. Close Dividends/Drawings (CR) to Retained Earnings (DR).
● Correction of Errors:
○ If an error is discovered before closing, an adjusting journal entry
corrects it.
○ If an error is discovered after closing and relates to the prior
period, it's a Prior Period Adjustment (PPA), and the correction is
made directly to Retained Earnings. PPAs must be disclosed in the
financial statements.
Summary (Chapter 2)
Chapter 2 details the Accounting Cycle, the standardized sequence of steps
used to record, classify, and summarize a company's financial data. It
emphasizes the importance of the Accrual Basis of Accounting, which dictates
that revenues and expenses be recognized when earned or incurred, essential
for GAAP/IFRS compliance. The critical phase of the cycle is the creation of
Adjusting Entries (A/E), which are needed at the end of a period to properly
account for deferrals (prepayments and unearned revenue) and accruals
(accrued revenue and accrued expense). After the A/Es are posted, the
Adjusted Trial Balance is used to create the financial statements. The cycle
concludes with Closing Entries, which reset the balances of all temporary
accounts (Revenues, Expenses, Dividends) to zero, transferring the net effect to
a permanent account like Retained Earnings.