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The Accounting Cycle

1. Journal Entries: The journal is a chronological record used to record all of the firm's transactions. The journalizing process requires three steps: (1) Each account that is affect by the transaction is listed, and each account is classified based on whether it is an asset, liability, shareholders' equity, revenue or expense. (2) The rules of debit and credit are used to determine whether each account increases or decreases as a result of the transaction. (3) The transaction is recorded in the journal with a brief explanation. 

2. Ledger Accounts: After a transaction is recorded in the general journal, it must be copied into each individual T-account. For example, cash will have its own T-account, with the left hand side being the "debit" side and the right hand side being the "credit" side. A debit increases an asset account, a credit decreases an asset account. A credit increases a liability or shareholder's equity account, including revenue, a debit decreases them. Dividends and expense accounts are contra equity accounts. That means they behave the opposite. A debit increases a dividend or equity account, a credit decreases them. 

3. Unadjusted Trial Balance: The trial balance is a list of all accounts and their balances in order, assets first, then liabilities, then shareholders' equity (including the revenue and expense accounts). The unadjusted trial balance is prepared to catch any mistakes that may have been made up until this point. After this trial balance, we typical make correcting journal entries for any accounting errors we may have found.

4. Adjusting Entries: Because companies are required to use accrual based accounting, the accounts at the unadjusted trial balance stage may not be ready for the financial statements. That is, adjusting entries may be required to ensure that deferrals, depreciation, accruals and perhaps inventory are properly recorded in the right period. 

Deferrals: Deferrals may include prepaid expenses, such as prepaid rent or supplies, as well as unearned revenue

Depreciation: Tangible capital assets such as land, buildings, furniture, machinery and equipment decline in usefulness and value over time. We spread this cost out over this time, and an expense for depreciation must be recorded each period.

Accruals: Accruals are expenses that have been incurred or revenues that have been earned, but which have not been paid or received in cash. 

5. Adjusted Trial Balance: We finish the adjusting process by preparing an adjusted trial balance. We often use a worksheet to prepare the adjusted trial balance. 

6. Financial Statements: From the adjusted trial balance we are able to prepare the financial statements: the income statement, the statement of owners' equity, the balance sheet and the statement of cash flows

7. Closing Entries: The closing entries allow us to set the business's revenue and expense accounts to zero so that we can start the next period. We do this by transferring these balances to retained earnings. We first close the revenue and expense accounts to a temporary account called Income Summary. We close the income summary account to retained earnings. We then close out dividends to retained earnings. (For a sole proprietorship, we close income summary and withdrawals to owners' equity.)

8. Post-Closing Trial Balance: On the post-closing trial balance, the temporary accounts (revenue, expenses, gains, losses, dividends and withdrawals) should have balances of zero and are not listed. However, all non-zero accounts, including retained earnings, are included. The post-closing trial balance provides the opening balances of all the ledger accounts for the next period. We use the post-closing trial balance to make a list of all of these ledger accounts, and ensure that all of the debit balances equal all of the credit balances in the accounts.


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