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The accounting cycle is performed during the accounting period, to analyze, record, classify, summarize, and report financial information.
Identify and complete the 8 steps in the Accounting Cycle
- The accounting cycle has 8 Steps.
- Each transaction must be analyzed to determine whether it qualifies as a business transaction.
- The accounting cycle runs within the accounting period.
- The goal of the accounting cycle is to produce financial statements for the company.
- bookkeeping: The skill or practice of keeping books or systematic records of financial transactions, e.g., income and expenses.
- source: The person, place or thing from which something (information, goods, etc. ) comes or is acquired.
- summarize: To give a recapitulation of the salient facts; to recapitulate or review
- Analyze transactions by examining source documents.
- Journalize transactions in the journal.
- Post journal entries to the accounts in the ledger.
- Prepare a trial balance of the accounts and complete the worksheet (includes adjusting entries ).
- Prepare financial statements.
- Journalize and post adjusting entries.
- Journalize and post closing entries.
- Prepare a post-closing trial balance.
The General Ledger: The General Ledger contains all entries from both the General Journal and the Special Journals.
As we walk through the steps of the accounting cycle, consider the following example. After a number of years as a successful CPA at a national firm, you decide to quit the rat race and pursue your true love -- yoga. You decide that Atlanta's Virginia-Highland neighborhood would be the perfect place to open an Ashtanga Yoga studio. Even better, your friend Solomon, a certified instructor, has just moved to town and is willing to teach at the studio. You hurriedly prepare to open the studio, Highland Yoga, by July 1. Pre-opening (before July 1) Prior to opening the business, you make the following transactions: 1. You contribute $4,000 in cash to start the business. 2. You purchase $500 worth of mats and other equipment for use during classes. 3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio. 4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31. July The following transactions take place during July. 1. You receive cash totaling $800 for classes. 2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3. 3. You pay rent for July of $1,000 on July 1. 4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15. August The following transactions take place during August. 1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September. 2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1. 3. Utilities total $150, payable September 15. 4. You pay rent of $1,000 on August 1. 5. You sell inventory costing $150 for a revenue of $225. 6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn't say when. 7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15. 8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.All business transactions must be recorded to the proper journal by double-entry book keeping.
Explain why the double entry system is used in accounting and the proper use of a T-account
- Source documents are important because they are the ultimate proof a business transaction has occurred.
- An account is a part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, stockholders' equity item, dividend, revenue, and expense.
- The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure.
- This double-entry procedure keeps the accounting equation in balance.
- account: A registry of pecuniary transactions; a written or printed statement of business dealings or debts and credits, and also of other things subjected to a reckoning or review
- debit: an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts
- credit: an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts
The General Ledger: The General Ledger contains all entries from both the General Journal and the Special Journals. Using a double entry system to record transactions keeps the accounts in balance.
The accounting requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure. This double-entry procedure keeps the accounting equation in balance. For each business transaction recorded, the total dollar amount of debits must equal the total dollar amount of credits. If one account (or accounts) is debited for $100, then another account (or accounts) must be credited for the same amount. The general ledger of all accounts is, simply, a comprehensive collection of T-accounts -- so called because there is a vertical line in the middle of each ledger page and a horizontal line at the top of each ledger page, like a large letter T. The account title will appear above the horizontal line, and debits and credits will appear to the left and right of the vertical line, respectively. Some typical accounts and their normal balances: Assets Debit Contra Asset Credit Liability Credit Contra Liability Debit Owner's Equity Credit Stockholder's Equity Credit Revenue Credit Contra Revenue Debit Expenses Debit Gains Credit Losses Debit
T-Account: T-accounts are so named because of their "T" shape, with the name of the account on top, and debits and credits on the left and right, respectively.
An account's normal balance will be the side on which increases are recorded. For example, assets and expenses normally have debit balances, and liabilities and revenues normally have credit balances. Continuing our example, how would we recognize and record the transactions involved in running our yoga studio? Pre-opening Prior to opening the business, you make the following transactions: 1. You contribute $4,000 in cash to start the business.Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)
2. You purchase $500 worth of mats and other equipment for use during classes.Cash -500, PPE 500; Assets(+), Assets(-)=0
3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Cash -400, Inventory 400; Assets(+), Assets(-)=0
4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)
July The following transactions take place during July. 1. You receive cash totaling $800 for classes.Cash 800, Service Revenue 800; Assets(+)= Equity(+)
2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)
3. You pay rent for July of $1,000 on July 1.Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)
4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.Utility Payable 200, Utility Expense 200; Liability(+)+Equity(-)=0.
August The following transactions take place during August. 1. You receive $1,500 in cash for classes on August 1. Of this amount, $1,000 is for an initiation fee. The remainder is for 2-month passes allowing unlimited classes in August and September.Cash 1,500, Unearned Revenue 500, Service Revenue 1,000; Assets(+1,500)=Liability(+500)+Equity(+1,000)
2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.Cash -300, Wage Payable 300, Instructor Expense 600; Assets(-300)=Liabilities(+300)+Equity(-600)
3. Utilities total $150, payable September 15.Utility Payable 150, Utility Expense 150; Liability(+)+Equity(-)=0
4. You pay rent of $1,000 on August 1.Cash -1,000, Rent Expense 1,000; Assets(-)=Equity(-)
5. You sell inventory costing $150 for a revenue of $225.a. Cash 225, Sales Revenue 225; Assets(+)=Equity(+)
b. Inventory -150, Cost of Goods Sold 150; Assets(-)=Equity(-)
6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn't say when.Cash 2,000, Loan Payable 2,000; Assets(+)=Liabilities(+)
7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.Cash -15, Service Revenue -15; Assets(-)=Equity(-)
8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.Cash -1,000, Contributed Capital -1,000; Assets(-)=Equity(-)
Items are entered into the general journal or the special journals via journal entries, also called journalizing.
Explain the correct procedure for making a journal entry in the General or Special Journal.
- Special journals are designed to facilitate the process of journalizing and posting transactions. They are used for the most frequent transactions in a business.
- Journal entries are prepared after examining the source document to see if a business transaction has taken place.
- The total amount debited and the total amount credited should always be equal, thereby ensuring the accounting equation is maintained.
- journalizing: the act of recording bookkeeping entries
- debit: an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts
- Facilitate: To make easy or easier.
- credit: an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts
The company's income statement: Closing the accounts prepares the ledger for the next accounting period.
Consider our example for the yoga studio. How would we record journal entries for each transaction? Pre-opening Prior to opening the business, you make the following transactions: 1. You contribute $4,000 in cash to start the business.Cash 4,000
Contributed capital 4,000
2. You purchase $500 worth of mats and other equipment for use during classes.PPE 500
Cash 500
3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Inventory 400
Cash 400
4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.Prepaid insurance 1,200
Cash 1,200
July The following transactions take place during July. 1. You receive cash totaling $800 for classes.Cash 800
Revenue 800
2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.Wage expense 600
Cash 300
Wage payable 300
3. You pay rent for July of $1,000 on July 1.Rent expense 1,000
Cash 1,000
4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.Utility expense 200
Utility payable 200
August The following transactions take place during August. 1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.Cash 1,500
Revenue 1,250
Unearned revenue 250
2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.Wage expense 600
Cash 300
Wage payable 300
3. Utilities total $150, payable September 15.Utility expense 150
Utility payable 150
4. You pay rent of $1,000 on August 1.Rent expense 1,000
Cash 1,000
5. You sell inventory costing $150 for a $225.Cash 225
Revenue 225
Cost of goods sold 150
Inventory 150
(these can be combined into a single entry if you choose. ) 6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn't say when.Cash 2,000
Loan Payable 2,000
Revenue 15
Cash 15
or
Refund expense 15
Cash 15
8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.Contributed capital 1,000
Cash 1,000
(this cannot be a dividend, because your balance of retained earnings is negative. )Journal Entry: Journal entries record business transactions so they may later be used to create financial statements.
Posting is recording in the ledger accounts the information contained in the journal.
Describe how posting affects the General Journal, Special Journal and General Ledger
- Posting is always from the journal to the ledger accounts.
- Postings can be made at the time the transaction is journalized; at the end of the day, week, or month; or as each journal page is filled.
- Cross-indexing is the placing of the account number of the ledger account in the general journal and the general journal page number in the ledger account.
- ledger: A book for keeping notes, especially one for keeping accounting records. (accounting) A collection of accounting entries consisting of credits and debits.
- posting: an item inserted into a register, ledger or diary
- general journal: where double entry bookkeeping entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount
The General Ledger: All transactions made by the company in relation to the bond must be recorded in its general ledger. The general ledger contains all entries from both the General Journal and the Special Journals.
Since accountants and bookkeepers often need to trace the origin of a ledger entry, they use cross-indexing. In cross-indexing a notation is made for each entry that indicates which general or special journal account the general ledger entry came from. This practice makes it easy to trace an entry back to the original transaction. The account number appears in the Posting Reference column of the General Journal.A trial balance is run during the accounting cycle to test whether the debits equal the credits.
Identify when the trial balance is performed and its purpose
- A trial balance is prepared after all the journal entries for the period have been recorded.
- The trial balance lists all of the ledger, both general journal and special, accounts and their debit or credit balances.
- A trial balance only checks the sum of debits against the sum of credits. If debits do not equal credits then the accountant or bookkeeper must determine why.
- equality: The fact of being equal; of having the same value.
- credit: an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts
- debit: an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts
The Trial Balance: The post-closing trial balance proves debits still equal credits after the closing entries have been made.
The accounts appear in this order: assets, liabilities, stockholders' equity, dividends, revenues, and expenses. Within the assets category, the most liquid (closest to becoming cash) asset appears first and the least liquid appears last. Within the liabilities, those liabilities with the shortest maturities appear first. If the total of the debit column does not equal the total value of the credit column then this would show that there is an error in the nominal ledger accounts. This error must be found before a profit and loss statement and balance sheet can be produced. The trial balance is usually prepared by a bookkeeper or accountant. The bookkeeper/accountant used journals to record business transactions. The journal entries were then posted to the general ledger. The trial balance is a part of the double-entry bookkeeping system and uses the classic 'T' account format for presenting values. A trial balance only checks the sum of debits against the sum of credits. If debits do not equal credits then the accountant or bookkeeper must determine why. In the example of Highland Yoga, the pre-opening trial balance would be calculated as follows: 1. You contribute $4,000 in cash to start the business.Cash 4,000, Contributed Capital 4,000; Assets(+)=Equity(+)
2. You purchase $500 worth of mats and other equipment for use during classes.Cash -500, PPE 500; Assets(+), Assets(-)=0
3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.Cash -400, Inventory 400; Assets(+), Assets(-)=0
4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December 31.Cash -1,200, Prepaid Insurance 1,200; Assets(+), Assets(-)
The trial balance for debits will be: 4,000 (cash) + 500 (PPE) + 400 (inventory) + 1,200 (prepaid insurance) = 6,100 The trial balance for credits will be: 4,000 (contributed capital) + 500 (cash) + 400 (cash) + 1,200 (cash) = 6,100 The calculation will be the same for the next two periods in the example, including any necessary adjustments. Some reasons why the general ledger may be out of balance:- Failing to post part of a journal entry.
- Posting a debit as a credit, or vice versa.
- Incorrectly determining the balance of an account.
- Recording the balance of an account incorrectly in the trial balance.
- Omitting an account from the trial balance.
- Making a transposition or slide error in the accounts or the journal.
Adjusting entries are journal entries made at the end of an accounting period that allocate income and expenses to their proper period.
Identify the types of adjusting entries and when and why they are made
- The matching principle of accrual accounting demands that revenues and associated costs are recognized in the same accounting period.
- The types of adjusting entries are prepayments, accrual, estimates, and inventory.
- Depreciation is an example of an estimated adjusting entry.
- In a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. However, an adjusting entry is not necessary for a company using perpetual inventory.
- Adjusting entries for expenses such as interest, taxes, rent, and salaries are the most common accrual entries.
- revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
- accrue: (intransitive, accounting) To be incurred as a result of the passage of time.The monthly financial statements show all the actual but only some of the accrued expenses.
The General Ledger: The General Ledger contains all entries from both the General Journal and the Special Journals.
There are several different types of adjusting entries. Each one accounts for a different situation.- Prepayments - adjusting entries for prepayments are necessary to account for cash that has been paid prior to delivery of goods or completion of services. When this cash is paid, it is first recorded in a prepaid expense asset account; the account is to be expensed either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies). The adjusting entry would credit the asset (e.g. supplies) account and debit a related expense account (e.g. supplies expense)
- Accruals - accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their cash payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable. Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.
- Estimates - An adjusting entry for an estimate occurs when the exact amount of an expense cannot easily be determined. For example, the depreciation of fixed assets is an expense that has to be estimated. The entry for bad debt expense can also be classified as an estimate.
- Inventory - in a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory.
Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)
b. Depreciation @ $20/monthAccumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)
a. Recognize insurance expensePrepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)
b. Depreciation @ $20/monthAccumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)
Cash -300, Wage Payable -300; Assets(-), Liabilities(-)
d. Pay utilities from JulyCash -200, Utility Payable -200; Assets(-), Liabilities(-)
The journal entries to record these transactions would be as follows: a. Expiration of insuranceInsurance expense.....................................200
-----Prepaid insurance..........................................200
b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense.................................20
-----Accumulated Depreciation.................................20
a. Expiration of insuranceInsurance expense.................................200
-----Prepaid insurance.................................200
b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense.................................20
-----Accumulated Depreciation........................20
c. Pay wage from JulyWage payable.................................300
-----Cash................................................300
d. Pay utility bill from JulyUtility payable.................................200
-----Cash.................................................200
Preparing financial statements requires preparing an adjusted trial balance, translating it into financial reports, and auditing them.
Explain the necessary steps to take before preparing the financial statements and the purpose of the statements
- The purpose of financial statements are to provide both business insiders and outsiders a concise, clear picture of the current financial status in the business. Therefore, the people who use the statements must be confident in its accuracy.
- Closing the books is simply a matter of ensuring that transactions that take place after the business's financial period are not included in the financial statements.
- Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory.
- When an audit is completed, the auditor will issue a report regarding whether the statements are accurate. To ensure a positive reports, some companies try to participate in opinion shopping. This practice is generally prohibited..
- opinion shopping: The process of contracting or rejecting auditors based on the type of opinion report they will issue on the auditee.
- adjusting entry: Journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred.
- audit: An independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures
Closing the books is simply a matter of ensuring that transactions that take place after the business's financial period are not included in the financial statements. For example, assume a business is preparing its financial statements with a December 31st year end. It acquires some property on January 14th. If the books are properly closed, that property will not be included on the balance sheet that is being prepared for the period on December 31st.
An adjusting entry is a journal entry made at the end of an accounting period that allocates income and expenditure to the appropriate years. Adjusting entries are generally made in relation to prepaid expenses, prepayments, accruals, estimates and inventory. Throughout the year, a business may spend funds or make assumptions that might not be accurate regarding the use of a good or service during the accounting period. Adjusting entries allow the company to go back and adjust those balances to reflect the actual financial activity during the accounting period. Failure to record the adjusting entries can result in understatement of expenses and overstatement of income, which ultimately can affect the amount of taxes paid. For example, assume a company purchases 100 units of raw material that it expects to use up during the current accounting period. As a result, it immediately expenses the cost of the material. However, at the end of the year the company discovers it only used 50 units. The company must then make an adjusting entry to reflect that, and decrease the amount of the expense and increase the amount of inventory accordingly. Using the trial balance, the company then prepares the four financial statements. These statements are:- The Balance Sheet: A summary of the company's assets, liabilities and equity;
- The Income Statement: A summary of the business's income, expenses, and profits
- The Statement of Cash Flows: A report on a company's cash flow activities, particularly its operating, investing and financing activities; and
- The Statement of Changes in Equity: A report that explains the changes of the company's equity throughout the reporting period
Wachovia National Bank 1906 financial statement
Once the company prepares its financial statements, it will contract an outside third party to audit it. An audit is an independent review and examination of records and activities to assess the adequacy of system controls, to ensure compliance with established policies and operational procedures, and to recommend necessary changes in controls, policies, or procedures. It is the audit that assures outside investors and interested parties that the content of the statements are correct. When an audit is completed, the auditor will issue a report with the findings. The findings can state anything from the statements are accurate to statements are misleading. To ensure a positive reports, some companies try to participate in opinion shopping. This is the process that businesses use to ensure it gets a positive review. Since Enron and the accounting scandals of the early 2000s, this practice has been prohibited.Transferring information from temporary accounts to permanent accounts is referred to as closing the books.
Identify the steps in the closing process
- Closing may be performed monthly or annually.
- There are four basic steps to closing the books.
- Closing the revenue accounts —transferring the balances in the revenue accounts to a clearing account called Income Summary.
- Closing the expense accounts—transferring the balances in the expense accounts to a clearing account called Income Summary.
- Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account (also known as the capital account).
- Closing the Dividends account—transferring the balance of the Dividends account to the Retained Earnings Account.
- account: A registry of pecuniary transactions; a written or printed statement of business dealings or debts and credits, and also of other things subjected to a reckoning or review
- revenue: Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
- temporary account: an account that is closed at the end of the period to be made a permanent account
- Closing the revenue accounts—transferring the balances in the revenue accounts to a clearing account called Income Summary.
- Closing the expense accounts—transferring the balances in the expense accounts to a clearing account called Income Summary.
- Closing the Income Summary account—transferring the balance of the Income Summary account to the Retained Earnings account (also known as the capital account).
- Closing the Dividends account—transferring the balance of the Dividends account to the Retained Earnings Account
A post-closing trial balance is a trial balance taken after the closing entries have been posted.
Explain the post-closing trial balance and why it is necessary
- A post-closing trial balance checks the accuracy of the closing process.
- A post-closing trial balance proves that the books are in balance at the start of the new accounting period.
- The post-closing trial balance differs from the adjusted trial balance.
- post-closing trial balance: a check that closing entries were done correctly
- debit: an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts
- closing entry: a journal entry made at the end of an accounting period to transfer temporary accounts to permanent accounts
- credit: an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts
- trial balance: a statement of the balances of all nominal accounts in a double-entry ledger, made to test their equality
- adjusted trial balance: a list of all the General ledger accounts (both revenue and capital) contained in the ledger of a business after adjusting entries are made
The Trial Balance: The post-closing trial balance proves debits still equal credits after the closing entries have been made.
While each accounting period has a beginning and an end, the periods do use information from the previous period. That is why it is necessary to run a post-closing trial balance. The preparation of a post-closing trial balance serves as a check on the accuracy of the closing process and ensures that the books are in balance at the start of the new accounting period. The post-closing trial balance differs from the adjusted trial balance in only two important respects: It excludes all temporary accounts since they have been closed, and it updates the retained earnings account to its proper ending balance.Adjusting entries often disrupts routine transactions, so they are simply reversed on the first day of the new period.
Describe why and how a reversing entry is made
- Reversing entries are optional, and some firms do not perform them.
- A reversing entry reverses an adjusting entry exactly.
- Reversing entries are performed because they reduce errors and save time.
- credit: an entry in the right hand column of an account; credits increase liability, income, and equity accounts and decrease asset and expense accounts
- debit: an entry in the left hand column of an account to record a debt; debits increase asset and expense accounts and decrease liability, income, and equity accounts
The General Ledger: Reversing entries prevent double recording expenses or revenues.