FINANCIAL ACCOUNTING & REPORTING 3

1
Review of the accounting process

Module 005 Week002- FinAcct3 Review of the

Accounting Process
Before financial statements are prepared and before adjusting entries are
recorded (internal transactions) at the end of an accounting period, an
unadjusted trial balance usually is prepared. A trial balance is simply a list of
the general ledger accounts and their balances at a particular date. Its
purpose is to check for completeness and to prove that the sum of the
accounts with debit balances equals the sum of the accounts with credit
balances, that is, the accounting equation is in balance.
Next step in the accounting cycle is to record in the general journal and post
to the ledger accounts the effect of internal events on the accounting
equation. These transactions do not involve an exchange transaction with
another entity and, therefore, are not initiated by a source document. They
are recorded at the end of any period when financial statements are
prepared. These transactions are commonly referred to as adjusting entries.
After the adjusting entries are posted to the general ledger accounts, the next
step in the accounting cycle is to prepare an adjusted trial balance. The term
adjusted refers to the fact that adjusting entries have now been posted to the
accounts.

At the end of this module, you will be able to:

1. Prepare the trial balance
2. Prepare the necessary adjusting entries and explain the reasons for the
entries
3. Define the nature of accruals and deferrals
4. Define the nature of asset depreciation and bad debts
5. Prepare the adjusted trial balance

Course Module
 FINANCIAL ACCOUNTING & REPORTING 3
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Review of the accounting process

Preparing a trial balance

A trial balance is a list of accounts and their balances at a given time. It is usually prepared
at the end of an accounting period. The trial balance lists the accounts in the order in which
they appear in the ledger, with debit balances listed in the left column and credit balances
in the right column. The totals of both columns must agree.
The trial balance proves the mathematical equality of debits and credits after posting. A
trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the
preparation of financial statements.
The procedures for preparing a trial balance consist of:
1. List the account titles and their balances in the appropriate debit or credit column
2. Total the debit and credit columns
3. Prove the equality of the two columns
A trial balance does not prove that a company recorded all transactions or that the
ledger is correct.
The trial balance may balance even when a company (1) fails to journalize a transaction,
(2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect
accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount
of a transaction.

Journalizing and posting adjusting entries

Adjusting entries are entries made at the end of an accounting period to bring all accounts
up to date on an accrual basis, so that the company can prepare correct financial statements.
The use of adjusting entries makes it possible to report on the balance sheet the appropriate
assets, liabilities, and owners’ equity at the statement date. Adjusting entries also make it
possible to report on the income statement the proper revenues and expenses for the period.
This occurs for the following reasons:
1. Some events are not recorded daily because it is not efficient to do so. Examples are
the use of supplies and the earning of wages by employees.
2. Some costs are not recorded during the accounting period because these costs expire
with the passage of time rather than as a result of recurring daily transactions.
Examples are asset depreciation, rent and insurance.
3. Some items may be unrecorded. Examples are utilities in which the bill will not be
received until the next accounting period.
The adjusting entries are based on two assumptions: the going concern and the accrual
basis.
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Review of the accounting process

An adjusting entry affects at least one nominal account and one real account.
A nominal account is one whose balance is brought to zero at the end of the reporting
period. They include income accounts, expense accounts, dividends, and drawings (in case
of single proprietorship and partnership).
A real account is one whose balance is brought forward to the next accounting period. These
are the balance sheet accounts (asset, liability, and equity).
Types of adjusting entries:
 Ending inventory under the periodic inventory system
 Accrual, which include accrual of expenses and accrual of income
 Deferrals, which include prepaid expenses and unearned income
 Depreciation of property, plant and equipment and amortization of intangibles
 Impairment of assets

Accrued expense, accrued revenues, prepaid expenses and unearned revenues

Types of adjusting entries

Adjusting entries are classified as either deferrals or accruals. Each of these classes has
subcategories, as follows:
Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used
or consumed.
2. Unearned revenues: Revenues received in cash and recoded as liabilities before they
are earned.
Accruals:
1. Accrued revenues: Revenues earned but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded
Adjusting entries for Deferrals
To defer means to postpone or delay. Deferrals are expenses or revenues that are
recognized at a date later than the point when cash was originally exchanged. The two types
of deferrals are prepaid expenses and unearned revenues.
If a company does not make an adjustment for these deferrals, the asset and liability are
overstated, and the related expense and revenue are understated.
Assets paid for and recorded before a company uses them are called prepaid expenses.
Examples of common prepayments are insurance, supplies, advertising, and rent.

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Review of the accounting process

Prepaid expenses are costs that expire either with the passage of time (e.g. rent and
insurance) or through use and consumption (e.g. supplies). An adjusting entry for prepaid
expenses results in a debit to an expense account and a credit to an asset account.
When companies receive cash before services are performed, they record a liability by
increasing (crediting) a liability account called unearned revenues. In other words, a
company now has a performance obligation to provide services to its customers. Items like
rent, magazine subscriptions, and customer deposits for future services are examples of
unearned revenues.
Unearned revenues are the opposite of prepaid expenses. Unearned revenue on the books of
one company is likely to be a prepayment on the books of the company that made the
advance payment.
The adjusting entry for unearned revenues results in a debit to a liability account and a credit
to a revenue account.
Adjusting entries for Accruals
Companies make adjusting entries for accruals to record revenues for services performed
and expenses incurred in the current accounting period.
Without an accrual adjustment, the revenue account (and the related asset account) or the
expense account (and the related liability account) are understated. Thus, the adjusting entry
for accruals will increase both a balance sheet and an income statement account.
Revenues for services performed but not yet recorded at the statement date are accrued
revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case
of interest revenue. An adjusting entry for accrued revenues results in a debit to an asset
account and a credit to a revenue account.
Accrued revenues also may result from services that have been performed but not yet billed
nor collected, as in the case of commissions and fees. These may be unrecorded because only
a portions of the total service has been performed and the company will not be billed until
the service has been completed.
Expenses incurred but not yet paid or recorded at the statement date are called accrued
expenses. Common examples are interest, rent, taxes and salaries.
Accrued expenses result from the same causes as accrued revenues. In fact, an accrued
expense on the books of one company is an accrued revenue to another company. The
adjusting entry for accrued expenses results in a debit to an expense account and a credit to
a liability account.

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Review of the accounting process

Asset depreciation and bad debts

Depreciation
Companies typically own various productive facilities, such as buildings, equipment, and
motor vehicles. These assets provide a service for a number of years. The term of service is
commonly referred to as the useful life of the asset.
To follow the expense recognition principle, the company reports a portion of the cost of a
long-lived asset as an expense during each period of the asset’s useful life. Depreciation is
the process of allocating the cost of an asset to expenses over its useful life in a rational and
systematic manner.
The need for making periodic adjusting entries for depreciation is the same as we described
for other prepaid expenses. That is, a company recognizes the expired cost during the period
and reports the unexpired cost at the end of the period.
The primary causes of depreciation of a productive facility are actual use, deterioration due
to the elements, and obsolescence.
The depreciation is an estimate rather than a factual measurement of the expired cost.
To record the annual depreciation, the company debits an expense account (depreciation
expense) and credits a contra-asset account (accumulated depreciation).
Accumulated depreciation is a contra asset account. A contra asset account offsets an asset
account on the balance sheet. This means that the accumulated depreciation account offsets
the equipment account on the balance sheet. Its normal balance is a credit. This account is
used in order to disclose both the original cost of the equipment and the total expired cost to
date.
Bad debts
Business entities sell on credit rather than only for cash to increase total sales and thereby
increase income.
However, an entity that sells on credit assumes the risk that some customers will not pay
their accounts. When an account becomes uncollectible, the entity has sustained a bad debt
loss. This loss is simply one of the costs of doing business on credit.
Proper recognition of revenues and expenses dictates recording bad debts as an expense of
the period in which a company recognizes revenue for services performed instead of the
period in which the company writes off the accounts or notes.
At the end of each period, a company estimates the amount of receivables that will later
prove to be uncollectible. It is based on various factors: the amount of bad debts it
experienced in past years, general economic conditions, how long the receivables are past
due, and other factors that indicate the extent of uncollectibility.

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Review of the accounting process

Bad debts are recognized when the loss is probable and the amount can be estimated
reliably.
This approach is parallel to the recognition of a “provision” which is both “probable and
measurable” in accordance with PAS 37.
There are three methods of estimating doubtful accounts, namely:
1. Aging the accounts receivable or “statement of financial position approach”
2. Percent of accounts receivable
3. Percent of sales or “income statement approach”

Preparing adjusted trial balance

Adjusted trial balance shows the balance of all accounts, after journalizing and posting all
adjusting entries, at the end of the accounting period. It lists the adjusted balance of all
general ledger accounts that are to be presented on the company’s financial statements.
The purpose of an adjusted trial balance is to prove the equality of the total debit balances
and the total credit balances in the ledger after all adjustments.

References and Supplementary Materials

Books and Journals
Valix, C., Peralta, J. & Valix, C.A; 2016; Financial Accounting Volume 3; Metro Manila,
Philippines; GIC Enterprises & Co., Inc.

Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield; 2013; Intermediate Accounting;

United States; John Wiley & Sons, Inc.

Online Supplementary Reading Materials

A Review of the Acounting Cycle; http://www.clinton.edu/repository/5649.pdf; October
30, 2017

Review of Accounting Cycle;

https://facweb.northseattle.edu/rwoods/ACC251_Folder/Ch02ReviewofAccountingCycle
.htm; October 30, 2017

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Review of the accounting process

Online Instructional Videos

The Accounting Cycle;
https://www.bing.com/videos/search?q=review+of+accounting+cycle&&view=detail&mid
=E3695079CD4D48B38840E3695079CD4D48B38840&FORM=VRDGAR; January 10, 2018

Intermediate Accounting I (Review of the Accounting Process 1);

https://www.bing.com/videos/search?q=review+of+accounting+cycle&&view=detail&mid
=305EC4D5EC5D9F95AC6F305EC4D5EC5D9F95AC6F&FORM=VRDGAR; January 10, 2018

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