- To increase these accounts, you credit them.
- To decrease these accounts, you debit them.
Watch Out: Contra Assets
A contra asset account (such as accumulated depreciation) acts in opposition to a standard asset account. While a normal asset has a debit balance, a contra asset carries a normal credit balance.
The Accounting Cycle in Motion
The accounting cycle is a continuous loop that moves through several critical stages.
1. Journal Entries and the General Ledger
The cycle begins by identifying transactions and preparing journal entries. Once a transaction is recorded in a journal, it is "posted" to the general ledger. The ledger is the master record where all transactions are categorized into their respective accounts, allowing you to see the running balance of every asset, liability, and equity item.
2. The Unadjusted Trial Balance
At the end of a period, an accountant prepares an unadjusted trial balance. This is a preliminary list of all account balances. Its primary purpose is to ensure that total debits equal total credits, serving as a first check for mathematical errors.
3. Adjusting Entries: Accrual vs. Cash Basis
This is where the distinction between accounting methods becomes vital.
- Cash Basis Accounting: Often used by very small businesses, this method records transactions only when cash actually changes hands.
- Accrual Basis Accounting: Used by mid-sized and large organizations, this method records revenue when it is earned and expenses when they are incurred, regardless of when the cash moves.
To adhere to the accrual basis, accountants must make adjusting entries at the end of the period. These entries account for items like:
- Accruals: Revenue earned but not yet billed, or expenses incurred but not yet paid.
- Deferrals: Cash received or paid in advance (e.g., prepaid insurance or unearned revenue).
- Non-cash items: Depreciation and bad debt expenses.
4. The Adjusted Trial Balance
After the adjusting entries are posted, the accountant generates the adjusted trial balance. This is the most accurate representation of the account values. It is calculated by taking the unadjusted balances and netting them with the impact of the adjustments.
Worked Example: Prepaid Insurance
Imagine a company has a Prepaid Insurance account (an asset) with an unadjusted debit balance of $$2,400$. At the end of the month, the accountant determines that $400 of that insurance has been "used up" (expired).
To record this, an adjusting entry is made:
- Debit Insurance Expense $400 (to increase the expense).
- Credit Prepaid Insurance $400 (to decrease the asset).
The adjusted trial balance will now show the correct, updated balance for Prepaid Insurance:
$2,400 (Unadjusted)−$400 (Adjustment)=$2,000 (Adjusted Balance).
From Trial Balance to Financial Statements
The ultimate goal of the accounting cycle is to produce financial statements, which provide a picture of the organization's health. The adjusted trial balance serves as the "source of truth" for these reports.
The Income Statement vs. The Balance Sheet
It is important to distinguish between these two reports based on the time they cover:
- The Income Statement: This shows performance over a range of time (e.g., "For the Year Ended July 31"). It nets revenues against expenses to determine net profit or loss.
- The Balance Sheet: This shows the financial position at a single point in time (e.g., "As of July 31"). It follows the fundamental accounting equation:
Assets=Liabilities+Equity.
The "Magic" of the Closing Process
You might notice that in an income statement, debits (expenses) and credits (revenues) rarely equal each other—if they did, there would be no profit or loss. However, in a trial balance, they must equal.
To bridge this gap, the cycle concludes with a "post-close" process where the net income from the income statement is moved into the equity section of the balance sheet. This integrates the period's performance into the company's total accumulated value, ensuring that the accounting equation remains perfectly balanced.
