The Accounting Cycle: Adjustments and Financial Statements

TL;DR

The accounting cycle ensures your financial records are accurate and up-to-date by making necessary adjustments before preparing financial statements. These adjustments properly match revenues with expenses and update asset and liability accounts. Skipping adjustments means your financial statements won't give a true picture of your business's performance or financial health.

1. The Mental Model

Think of the accounting cycle like a finely tuned engine: each part needs to work together perfectly to produce reliable financial information. Adjustments are like the final calibration before you get to see how well the engine (your business) is actually running through its financial statements.

2. The Core Material

You've learned about recording transactions as they happen. But some events, like using up supplies or earning revenue over time, aren't tied to a specific cash transaction right away. That's where adjusting entries come in. They're made at the end of an accounting period (e.g., month, quarter, year) to ensure your financial statements follow the accrual basis of accounting. This means:

• Revenue Recognition Principle: You record revenue when it's earned, regardless of when cash is received.
• Expense Recognition Principle (Matching Principle): You record expenses when they're incurred to generate revenue, regardless of when cash is paid.

Adjusting entries never involve the Cash account. They typically affect one balance sheet account (asset or liability) and one income statement account (revenue or expense).

Types of Adjusting Entries

Photo by Mikhail Nilov on Pexels

There are four main types of adjusting entries:

1. Deferrals:

   • Prepaid Expenses: Cash was paid before the expense was incurred (e.g., rent paid in advance, insurance, supplies). You initially debit an asset account (e.g., Prepaid Rent) and credit Cash. The adjustment then debits an expense account (e.g., Rent Expense) and credits the asset account for the portion used up.
   • Unearned Revenues: Cash was received before the revenue was earned (e.g., customer pays in advance for services). You initially debit Cash and credit a liability account (e.g., Unearned Service Revenue). The adjustment then debits the liability account and credits a revenue account (e.g., Service Revenue) for the portion earned.

2. Accruals:

   • Accrued Revenues: Revenue was earned before cash was received (e.g., services performed but not yet billed). The adjustment debits an asset account (e.g., Accounts Receivable) and credits a revenue account (e.g., Service Revenue).
   • Accrued Expenses: Expense was incurred before cash was paid (e.g., salaries owed to employees, interest owed on a loan). The adjustment debits an expense account (e.g., Salaries Expense) and credits a liability account (e.g., Salaries Payable).

Another common adjustment is depreciation. This is the process of allocating the cost of a long-lived asset (like equipment or buildings) over its useful life. You debit Depreciation Expense and credit Accumulated Depreciation, a contra-asset account that reduces the book value of the asset.

After all adjusting entries are made and posted, you'll prepare an Adjusted Trial Balance. This list of all accounts and their balances ensures that total debits equal total credits after adjustments. This is the source for creating your financial statements.

graph TD
    A["Unadjusted Trial Balance"] --> B["Identify Adjustments Needed"]
    B --> C1["Prepaid Expenses Used?"]
    B --> C2["Unearned Revenue Earned?"]
    B --> C3["Revenue Accrued?"]
    B --> C4["Expenses Accrued?"]
    B --> C5["Depreciation Incurred?"]
    C1 --> D["Journalize & Post Adjusting Entries"]
    C2 --> D
    C3 --> D
    C4 --> D
    C5 --> D
    D --> E["Adjusted Trial Balance"]
    E --> F1["Income Statement"]
    E --> F2["Retained Earnings Statement"]
    E --> F3["Balance Sheet"]
    F1 --> G["Closing Entries"]
    F2 --> G
    F3 --> G
    G --> H["Post-Closing Trial Balance"]

Financial Statements

Photo by RDNE Stock project on Pexels

Once you have your Adjusted Trial Balance, you can prepare the main financial statements in this order:

1. Income Statement: Shows revenues and expenses over a period of time, resulting in Net Income or Net Loss. It tells you if you made money.

   • Formula: Revenues - Expenses = Net Income (or Loss)

2. Retained Earnings Statement: Shows how the retained earnings balance changed over a period of time, reflecting net income, dividends, and prior period's retained earnings.

   • Formula: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

3. Balance Sheet: Presents a snapshot of assets, liabilities, and owner's equity at a specific point in time. It shows what you own, what you owe, and the owner's stake.

   • Formula: Assets = Liabilities + Owner's Equity (the accounting equation!)

3. Worked Example

Let's say it's December 31, and your unadjusted trial balance shows:
* Supplies: $2,000 (debit)
* Unearned Service Revenue: $1,500 (credit)
* Salaries Expense: $8,000 (debit)

Here are the additional facts you gather:
1. A count of supplies on December 31 shows $800 of supplies remaining.
2. You performed $1,000 of the services for which you had received cash in advance (recorded as Unearned Service Revenue).
3. You owe employees $500 in salaries for work done in December, which will be paid in January.

Let's make the adjustments and see their effect:

1. Adjusting for Supplies:
* You started with $2,000, and $800 remains. So, $2,000 - $800 = $1,200 of supplies were used.
* Debit Supplies Expense $1,200
* Credit Supplies $1,200
* Effect: Supplies (asset) decreases by $1,200; Supplies Expense increases by $1,200.

2. Adjusting for Unearned Service Revenue:
* You earned $1,000 of the unearned revenue.
* Debit Unearned Service Revenue $1,000
* Credit Service Revenue $1,000
* Effect: Unearned Service Revenue (liability) decreases by $1,000; Service Revenue (revenue) increases by $1,000.

3. Adjusting for Accrued Salaries:
* You owe $500 in salaries.
* Debit Salaries Expense $500
* Credit Salaries Payable $500
* Effect: Salaries Expense increases by $500; Salaries Payable (liability) increases by $500.

After these adjustments, your relevant accounts would look like this (assuming no other entries):

Now, if you were preparing your Income Statement, you'd show $1,000 in Service Revenue and $1,200 for Supplies Expense and $8,500 for Salaries Expense (plus any other expenses). Your Balance Sheet would show $800 in Supplies, $500 in Unearned Service Revenue, and