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Accrual accounting requires a business to record revenues and expenses in the period in which they are earned or incurred, regardless of when payment occurs Keythman. When payment occurs on a date that is different from the date on which a company actually earns or incurs a revenue or expense, the company creates an adjusting journal entry to record the revenue or expense in the appropriate period.
Accrual accounting is done in two ways; by recording revenues when earned and expenses when incurred. When "a sale is made on credit, revenue is recorded before the cash is received in the Accounts Receivable account" ("Keythman"). When an expense is incurred on credit, an expense is recorded before the cash is paid in the Accounts Payable account.
Major Types of Adjusting Entries
There are four types of adjusting journal entries used in a small business.
Accrued revenue is an asset account
Â Â Revenue is recognized before cash is received
Â Â Cash to be received in the future is an asset account
Accrued revenue occurs when you make a sale and collect payment at a later date. "An adjusting entry to record accrued revenue increases the revenue account and the accounts receivable account by the amount of the sale" ("Keythman"). Accounts receivable shows the amount customers owe you.
Accrued expense is a liability account
Â Â Expense is recognized before cash is paid
Â Â Cash to be paid in the future is a liability account
An accrued expense is one that you incur but have not yet paid. "An adjusting entry to record an accrued expense increases the expense account that corresponds to the expense incurred and increases the appropriate payable account" ("Keythman"). A payable account shows the amount you owe other parties.
Deferred revenue is a liability account
Revenue is recognized after cash is received
Cash received in advance is a liability account
Deferred, or unearned, revenue occurs when you "receive cash up front for services you will provide in the future" ("Keythman"). As you provide the services to earn the revenue, you create an adjusting entry that increases the revenue account and reduces the unearned revenue account by the amount earned.
Deferred expense is an asset account
Â Â Expense is recognized after cash is paid
Â Â Cash paid in advance is an asset account
A deferred, or prepaid, expense is "one for which you paid cash up front at an earlier date but which you have not yet incurred" ("Keythman"). As you incur the expense, you create an adjusting entry that increases the appropriate expense account and reduces the prepaid expense account.
Preparing a Trial Balance
A trial balance is a list and total of all the debit and credit accounts for an entity for a given period - usually a month.Â The "format of the trial balance is a two-column schedule with all the debit balances listed in one column and all the credit balances listed in the other" ("Money Instructor").Â The trial balance is prepared after all the transactions for the period have been journalized and posted to the General Ledger.
Preparing the trial balance is the process of totaling the debits and credits in your chart of accounts, then making sure that the sum of all debits equals the sum of all credits - that the two amounts balance.
The Purpose of a Trial Balance
The adjusted trial balance reports all of the balances in the general ledger after the end-of-period adjusting entries have been made and posted. Generally, all of a company's balance sheet accounts are listed, followed by the statement of retained earnings accounts, and finally, the income statement accounts.
Using the Worksheet
A worksheet consists of a trial balance, the end-of-period adjusting entries, an adjusted trial balance, and columns showing the ledger accounts arranged as an income statement and as a balance sheet. The completed worksheet is used as the basis for preparing financial statements and for recording, adjusting, and closing entries in the formal accounting records.
The completed work sheet aids the accountant in three principal tasks:
Preparing the Financial Statements
Recording the Adjusting Entries
Recording the Closing Entries
Account balances have been sorted into Income Statement and Balance Sheet columns. "Adjusting entries are copied to the general journal and then posted to the general ledger. Closing entries are entered in the journal and posted to the ledger" ("Needles"). All accounts that need closing, except Dividends, may be found in the Income Statement columns of the work sheet.
Closing the Books
At the end of an accounting cycle, the books will need to be closed to start a new cycle. "Adjusting journal entries will need to be done to record any amounts accrued for the period that are not yet listed and to remove any deferred items" ("Accounting Explained"). Closing journal entries will need to be done to rid the ledger of revenue and expense accounts, attributing the amounts to income and retained earnings.
At the end of the accounting period, the balances in temporary accounts are transferred to an income summary account and a retained earnings account, thereby resetting the balance of the temporary accounts to zero to begin the next accounting period.
First, the revenue accounts are closed by transferring their balances to the income summary account:
Service revenue account is debited and its balance it credited to income summary account.
Next, the expense accounts are closed by transferring their balances to the income summary account:
Each expense account is credited and the income summary is debited for the sum of the balances of expense accounts.
The income summary account is then closed to retained earnings:
Income summary account is "debited and retained earnings account is credited for the an amount equal to the excess of service revenue over total expenses i.e. the net balance in income summary account after posting the first two closing entries" ("NetMBA").
Finally, the dividends account is closed to retained earnings:
The last closing entry transfers the dividend or withdrawal account balance to the retained earnings account.
Once posted to the ledger, these journal entries serve the purpose of setting the temporary revenue, expense, and dividend accounts back to zero in preparation for the start of the next accounting period.
Post-Closing Trial Balance
A post-closing trial balance is a list of balances of ledger accounts prepared after closing entries have been passed and posted to the ledger accounts. "Since the closing entries transfer the balances of temporary accounts to the retained earnings account, the new balances of temporary accounts are zero and therefore they are not listed on a post-closing trial balance" ("NetMBA"). However, all the other accounts having non-negative balances are listed including the retained earnings account.
The preparation of post-closing trial balance is the last step of the accounting cycle and its purpose is "to be sure that sum of debits equal the sum of credits" ("NetMBA") before the start of new accounting period. It provides the openings balances for the ledger accounts of the new accounting period.
"Accounting Trial Balance Example and Financial Statement Preparation." Money Instructor.com. Money Instructor. N.d. Web. 17 Apr 2013
"Closing Entries." NetMBA Business Knowledge Center. NetMBA.com N.d. Web. 17 Apr 2013
Keythman, Bryan "Four Types of Adjusting Journal Entries." Chron.com. Demand Media. N.d. Web. 17 Apr 2013
Needles, Belverd "Completing the Accounting Cycle." DePaul University. University of New Orleans. N.d. Web. 17 Apr 2013
"Post-Closing Trial Balance." AccountingExplained.com. Accounting Explained. N.d. Web. 17 Apr 201