Accounting CycleAccounting cycle is the financial process starting with recordingbusiness transactionsand leading up to the preparation offinancial statements. This process demonstrates the purpose offinancial accounting--to create useful financial information in the form ofgeneral-purpose financial statements. In other words, the sole purpose of recording transactions and keeping track of expenses and revenues is turn this data into meaning financial information by presenting it in the form of a balance sheet, income statement, statement of owner's equity, and statement of cash flows.The accounting cycle is a set of steps that are repeated in the same order every period. The culmination of these steps is the preparation of financial statements. Some companies prepare financial statements on a quarterly basis whereas other companies prepare them annually. This means that quarterly companies complete one entire accounting cycle every three months while annual companies only complete one accounting cycle per year.Accounting Cycle StepsThis cycle starts with a business event. Bookkeepers analyze the transaction and record it in the general journal with a journal entry. The debits and credits from the journal are then posted to the general ledger where an unadjusted trial balance can be prepared.After accountants and management analyze the balances on the unadjusted trial balance, they can then make end of period adjustments like depreciation expense and expense accruals. These adjusted journal entries are posted to the trial balance turning it into an adjusted trial balance.Now that all the end of the year adjustments are made and the adjusted trial balance matches the subsidiary accounts, financial statements can be prepared. After financial statements are published and released to the public, the company can close its books for the period. Closing entries are made and posted to the post closing trial balance.At the start of the next accounting period, occasionally reversing journal entries are made to cancel out the accrual entries made in the previous period. After the reversing entries are posted, the accounting cycle starts all over again with the occurrence of a new business transaction.Here is a simplified summary of the steps in a traditional accounting cycle. Some textbooks list more steps than this, but I like to simplify them and combine as many steps as possible. -- Identify business events, analyze these transactions, and record them asjournal entries -- Post journal entries to applicable T-accounts orledger accounts -- Prepare anunadjusted trial balancefrom the general ledger -- Analyze the trial balance and make end of periodadjusting entries -- Post adjusting journal entries and prepare theadjusted trial balance -- Use the adjusted trial balance toprepare financial statements -- Close all temporary income statement accounts withclosing entries -- Prepare thepost closing trial balancefor the next accounting period -- Preparereversing entriesto cancel temporary adjusting entries if applicable

Flow ChartAfter this cycle is complete, it starts over at the beginning. Here is an accounting cycle flow chart.

As you can see, the cycle keeps revolving every period. Note that some steps are repeated more than once during a period. Obviously, business transactions occur and numerous journal entries are recording during one period. Only one set of financial statements is prepared however.Throughout this section, we'll be looking at the business events and transactions that happen to Paul's Guitar Shop, Inc. over the course of its first year in business. Let's take a look at how Paul starts his accounting cycle below.

Journal Entries T-Accounts Unadjusted Trial Balance Adjusting Entries Adjusted Trial Balance Financial Statements Accounting Worksheet Closing Entries Income Summary Account Post Closing Trial Balance Reversing Entries

Journal EntriesJournal entriesare the first step in the accounting cycle and are used to record allbusiness transactionsand events in the accounting system. As business events occur throughout the accounting period, journal entries are recorded in the general journal to show how the event changed in the accounting equation. For example, when the company spends cash to purchase a new vehicle, the cash account is decreased or credited and the vehicle account is increased or debited.Identify TransactionsThere are generally three steps to making a journal entry. First, the business transaction has to be identified. Obviously, if you don't know a transaction occurred, you can't record one. Using our vehicle example above, you must identify what transaction took place. In this case, the company purchased a vehicle. This means a new asset must be added to the accounting equation.Analyze TransactionsAfter an event is identified to have an economic impact on the accounting equation, the business event must be analyzed to see how the transaction changed the accounting equation. When the company purchased the vehicle, it spent cash and received a vehicle. Both of these accounts are asset accounts, so the overall accounting equation didn't change. Total assets increased and decreased by the same amount, but an economic transaction still took place because the cash was essentially transferred into a vehicle.Journalizing TransactionsAfter the business event is identified and analyzed, it can be recorded. Journal entries use debits and credits to record the changes of the accounting equation in the general journal. Traditional journal entry format dictates that debited accounts are listed before credited accounts. Each journal entry is also accompanied by the transaction date, title, and description of the event. Here is an example of how the vehicle purchase would be recorded.Since there are so many different types of business transactions, accountants usually categorize them and record them in separate journal to help keep track of business events. For instance, cash was used to purchase this vehicle, so this transaction would most likely be recorded in the cash disbursements journal. There are numerous other journals like the sales journal, purchases journal, and accounts receivable journal.ExampleWe are following Paul around for the first year as he starts his guitar store called Paul's Guitar Shop, Inc. Here are the events that take place.Journal Entry 1 -- Paul forms the corporation by purchasing 10,000 shares of $1 par stock.

Journal Entry 2 -- Paul finds a nice retail storefront in the local mall and signs a lease for $500 a month.

Journal Entry 3 -- PGS takes out a bank loan to renovate the new store location for $100,000 and agrees to pay $1,000 a month. He spends all of the money on improving and updating the store's fixtures and looks.

Journal Entry 4 -- PGS purchases $50,000 worth of inventory to sell to customers on account with its vendors. He agrees to pay $1,000 a month.

Journal Entry 5 -- PGS's first rent payment is due.

Journal Entry 6 -- PGS has a grand opening and makes it first sale. It sells a guitar for $500 that cost $100.

Journal Entry 7 -- PGS sells another guitar to a customer on account for $300. The cost of this guitar was $100.

Journal Entry 8 -- PGS pays electric bill for $200.

Journal Entry 9 -- PGS purchases supplies to use around the store.

Journal Entry 10 -- Paul is getting so busy that he decides to hire an employee for $500 a week. Pay makes his first payroll payment.

Journal Entry 11 -- PGS's first vendor inventory payment is due of $1,000.

Journal Entry 12 -- Paul starts giving guitar lessons and receives $2,000 in lesson income.

Journal Entry 13 -- PGS's first bank loan payment is due.

Journal Entry 14 -- PGS has more cash sales of $25,000 with cost of goods of $10,000.

Journal Entry 15 -- In lieu of paying himself, Paul decides to declare a $1,000 dividend for the year.

Now that these transactions are recorded in their journals, they must be posted to the T-accounts orledger accountsin the next step of theaccounting cycle.Here is an additional list of the most common business transactions and the journal entry examples to go with them. Sale Entry Depreciation Expense Entry Accumulated Depreciation Entry Accrued Expense Entry

Post Journal Entries to T-Accounts or Ledger AccountsOnce journal entries are made in thegeneral journalor subsidiary journals, they must be posted and transferred to theT-accountsorledger accounts. This is the second step in the accounting cycle.The purpose of journalizing is to record the change in theaccounting equationcaused by a business event. Ledger accounts categorize these changes ordebits and creditsinto specific accounts, so management can have useful information for budgeting and performance purposes.Since management uses these ledger accounts, journal entries are posted to the ledger accounts regularly. Most companies have computerized accounting systems that update ledger accounts as soon as the journal entries are input into the accounting software. Manual accounting systems are usually posted weekly or monthly. Just like journalizing, posting entries is done throughout each accounting period.T-AccountLedger accounts use the T-account format to display the balances in each account. Each journal entry is transferred from the general journal to the corresponding T-account. The debits are always transferred to the left side and the credits are always transferred to the right side of T-accounts.Since most accounts will be affected by multiple transactions, there are usually several numbers in both the debit and credit columns. Account balances are always calculated at the bottom of each T-account. Notice that these are account balancesnot column balances. The total difference between the debit and credit columns will be displayed on the bottom of the corresponding side. In other words, an account with a credit balance will have a total on the bottom of the right side of the account.As a refresher of the accounting equation, allasset accountshave debit balances andliabilityandequity accountshave credit balances. All contra accounts have opposite balances.Since so many transactions are posted at once, it can be difficult post them all. In order to keep track of transactions, I like to number each journal entry as its debit and credit is added to the T-accounts. This way you can trace each balance back to the journal entry in the general journal if you have any questions later in the accounting cycle.ExampleLet's post thejournal entriesthat Paul's Guitar Shop, Inc. made during the first year in business to the ledger accounts.

As you can see, all of the journal entries are posted to their respective T-accounts and the account balances are calculated on the bottom of each ledger account.Now these ledgers can be used to create anunadjusted trial balancein the next step of theaccounting cycle.

Unadjusted Trial BalanceAn unadjusted trial balance is a listing of all the business accounts that are going to appear on the financial statements before year-end adjusting journal entries are made. That is why this trial balance is called unadjusted.This is the third step in theaccounting cycle. After the all the journal entries are posted to the ledger accounts, the unadjusted trial balance can be prepared.FormatAn unadjusted trial balance is displayed in three columns: a column for account names, debits, and credits. Accounts with debit balances are listed in the left column and accounts with credit balances are listed on the right.Accounts are usually listed in order of their account number. Most charts of accounts are numbered inbalance sheetorder, so the unadjusted trial balance also displays the account numbers in balance sheet order starting with theassets,liabilities, andequity accountsand ending withincomeandexpense accounts.Both the debit and credit columns are calculated at the bottom of a trial balance. As with theaccounting equation, these debit and credit totals must always be equal. If they aren't equal, the trial balance was prepared incorrectly or the journal entries weren't transferred to the ledger accounts accurately.As with all financial reports, trial balances are always prepared with a heading. Typically, the heading consists of three lines containing the company name, name of the trial balance, and date of the reporting period.

PreparationPosting accounts to the unadjusted trial balance is quite simple. Basically, each one of the account balances is transferred from the ledger accounts to the trial balance. All accounts with debit balances are listed on the left column and all accounts with credit balances are listed on the right column. That's all there is to it.ExampleAfter Paul's Guitar Shop, Inc. records itsjournal entriesand posts them to ledger accounts, it prepares this unadjusted trial balance.

As you can see, all the accounts are listed with their account numbers with corresponding balances. In accordance withdouble entry accounting, both of the debit and credit columns are equal to each other.Managers and accountants can use this trial balance to easily assess accounts that must be adjusted or changed before the financial statements are prepared.After the accounts are analyzed, the trial balance can be posted to theaccounting worksheet andadjusting journal entriescan be prepared.

Adjusted Trial BalanceAn adjusted trial balance is a listing of all company accounts that will appear on thefinancial statementsafter year-end adjusting journal entries have been made.Preparing an adjusted trial balance is the fifth step in theaccounting cycle and is the last step beforefinancial statementscan be produced.

FormatAn adjusted trial balance is formatted exactly like an unadjusted trial balance. Three columns are used to display the account names, debits, and credits with the debit balances listed in the left column and the credit balances are listed on the right.Like the unadjusted trial balance, the adjusted trial balance accounts are usually listed in order of their account number or in balance sheet order starting with theassets,liabilities, andequity accountsand ending withincomeandexpense accounts.Both the debit and credit columns are calculated at the bottom of a trial balance. As with the accounting equation, these debit and credit totals must always be equal. If they aren't equal, the trial balance was prepared incorrectly or the journal entries weren't transferred to the ledger accounts accurately.As with all financial reports, trial balances are always prepared with a heading. Typically, the heading consists of three lines containing the company name, name of the trial balance, and date of the reporting period.

PreparationThere are two main ways to prepare an adjusted trial balance. Both ways are useful depending on the site of the company and chart of accounts being used.You could post accounts to the adjusted trial balance using the same method used in creating the unadjusted trial balance. The account balances are taken from the T-accounts or ledger accounts and listed on the trial balance. Essentially, you are just repeating this process again except now the ledger accounts include the year-end adjusting entries.You could also take the unadjusted trial balance and simply add the adjustments to the accounts that have been changed. In many ways this is faster for smaller companies because very few accounts will need to be altered.Note that only active accounts that will appear on the financial statements must to be listed on the trial balance. If an account has a zero balance, there is no need to list it on the trial balance.ExampleUsing Paul'sunadjusted trial balanceand hisadjusted journal entries, we can prepare the adjusted trial balance.Once all the accounts are posted, you have to check to see whether it is in balance. Remember that all trial balances' debit and credits must equal.Now that the trial balance is made, it can be posted to theaccounting worksheetand thefinancial statementscan be prepared.

Financial Statement PreparationPreparinggeneral-purpose financial statements; including the balance sheet, income statement, statement of retained earnings, and statement of cash flows; is the most important step in the accounting cycle because it represents the purpose offinancial accounting. In other words, the conceptfinancial reportingand the process of theaccounting cycleare focused on providing external users with useful information in the form of financial statements. These statements are the end product of the accounting system in any company. Basically, preparing these statements is what financial accounting is all about.PreparationPreparing general-purpose financial statements can be simple or complex depending on the size of the company. Some statements need footnote disclosures while other can be presented without any. Details like this generally depend on the purpose of the financial statements.For instance, banks often want basic financials to verify the a company can pay its debts, while the SEC required audited financial statements from all public companies.Financial statements are prepared by transferring the account balances on the adjusted trial balance to a set of financial statement templates. We will discuss the financial statement form in the next section of the course.ExampleHere is an example of Paul's Guitar Shop, Inc.'s financial statements based on hisadjusted trial balancein our previous example.As you can see all four general-purpose financial statements are prepared and presented here. Paul can use these statements internally to gauge the performance of his store for the year or he can issue them to lenders or investors to help raise funds to expand the store.Once the statements have been prepared, Paul can add the financial statements to theaccounting worksheetand close his books for the year by recordingclosing entriesin the nextaccounting cyclestep.There is more technical information about how to prepare financial statements in the next section of my accounting course.Accounting WorksheetAn accounting worksheet is a tool used to help bookkeepers and accountants complete theaccounting cycleand prepare year-end reports like unadjusted trial balances,adjusting journal entries,adjusted trial balances, andfinancial statements.FormatThe accounting worksheet is essentially a spreadsheet that tracks each step of the accounting cycle. The spreadsheet typically has five sets of columns that start with theunadjusted trial balanceaccounts and end with the financial statements. In other words, an accounting worksheet is basically a spreadsheet that shows all of the major steps in the accounting cycle side by side.Each step lists its debits and credits with totals calculated at the bottom. Just like the trial balances, the work sheet also has a heading that consists of the company name, title of the report, and time period the report documents.

ExampleHere is what Paul's Guitar Shop's year-end would look like in accounting worksheet format for theaccounting cycleexamples in this section.

As you can see, the worksheet lists all the trial balances and adjustments side by side. During the accounting cycle process, an accounting worksheet can be helpful to keep track of the different steps and reduce errors.It can also be used for a analytical and summary tool to show how accounts were originally posted to the ledger and what adjustments were made before they were presented on the financial statements.I suggest using the accounting worksheet for all your year-end accounting problems. It saves time and maintains accuracy in the process. Here is a downloadable excel version of this accounting worksheet template, so you can use it with your accounting homework.

Closing EntriesClosing entries, also called closing journal entries, are entries made at the end of an accounting period to zero out all temporary accounts and transfer their balances to permanent accounts. In other words, the temporary accounts are closed or reset at the end of the year. This is commonly referred to as closing the books.Temporary accountsare income statement accounts that are used to track accounting activity during an accounting period. For example, the revenues account records the amount of revenues earned during an accounting periodnot during the life of the company. We don't want the 2015 revenue account to show 2014 revenue numbers.Permanent accountsare balance sheet accounts that track the activities that last longer than an accounting period. For example, a vehicle account is a fixed asset account that is recorded on the balance. The vehicle will provide benefits for the company in future years, so it is considered a permanent account.At the end of the year, all the temporary accounts must be closed or reset, so the beginning of the following year will have a clean balance to start with. In other words, revenue, expense, and withdrawal accounts always have a zero balance at the start of the year because they are always closed at the end of the previous year. This concept is consistent with thematching principle.Closing Entry TypesTemporary accounts can either be closed directly to the retained earnings account or to an intermediate account called theincome summary account. The income summary account is then closed to the retained earnings account. Both ways have their advantages.Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow. The total of the income summary account after the all temporary accounts have been close should be equal to the net income for the period.Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step. There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again.Both closing entries are acceptable and both result in the same outcome. All temporary accounts eventually get closed to retained earnings and are presented on thebalance sheet.ExampleIn this example we will close Paul's Guitar Shop, Inc.'s temporary accounts using the income summary account method from hisfinancial statementsin the previous example.There are three general closing entries that must be made.Close all revenue and gain accountsAll of Paul's revenue or income accounts are debited and credited to the income summary account. This resets the income accounts to zero and prepares them for the next year.

Remember that all revenue, sales, income, and gain accounts are closed in this entry. Paul's business or has a few accounts to close.Close all expense and loss accountsAll expense accounts are then closed to the income summary account by crediting the expense accounts and debiting income summary.

Close all dividend or withdrawal accounts

Since dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account. These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings.Now that all the temporary accounts are closed, the income summary account should have a balance equal to the net income shown on Paul'sincome statement. Now Paul must close theincome summary accountto retained earnings in the next step of the closing entries.

Income Summary AccountThe income summary account is a temporary account used to store income statement account balances, revenue and expense accounts, during the closing entry step of theaccounting cycle. In other words, theincome summary accountis simply a placeholder for account balances at the end of the accounting period while closing entries are being made.At the end of each accounting period, all of the temporary accounts are closed. You might have heard people call this "closing the books." Temporary accounts like income and expenses accounts keep track of transactions for a specific period and get closed or reset at the end of the period. This way each accounting period starts with a zero balance in all the temporary accounts, so revenues and expenses are only recorded for current years.vThere are two ways to close temporary accounts. You can either close these accounts directly to the retained earnings account or close them to the income summary account.Closing temporary accounts to the income summary account does take an extra step, but it also provides and an audit trail showing therevenues,expenses, and net income for the year.Once the temporary accounts are closed to the income summary account, the balances are held there until final closing entries are made. This provides a useful check for errors. Once all the temporary accounts are closed, the balance in the income summary account should be equal to the net income of the company for the year.Then the income summary account is zeroed out and transfers its balance to the retained earnings (for corporations) or capital accounts (for partnerships). This transfers the income or loss from an income statement account to a balance sheet account. This is the only time that the income summary account is used. For the rest of the year, the income summary account maintains a zero balance.ExampleAfter Paul's Guitar Shop prepares itsclosing entries, the income summary account has a balance equal to its net income for the year. This balance is then transferred to the retained earnings account in a journal entry like this.

After this entry is made, all temporary accounts, including the income summary account, should have a zero balance.Now that Paul's books are completely closed for the year, he can prepare thepost closing trial balanceand reopen his books withreversing entriesin the next steps of theaccounting cycle.

Post Closing Trial BalanceThe post closing trial balance is a list of all accounts and their balances after theclosing entrieshave been journalized and posted to the ledger. In other words, the post closing trial balance is a list of accounts or permanent accounts that still have balances after the closing entries have been made.This accounts list is identical to the accounts presented on the balance sheet. This makes sense because all of the income statement accounts have been closed and no longer have a current balance. The purpose of preparing the post closing trial balance is verify that all temporary accounts have been closed properly and the total debits and credits in the accounting system equal after the closing entries have been made.FormatAn post closing trial balance is formatted the same as the other trial balances in theaccounting cycledisplaying in three columns: a column for account names, debits, and credits.Since only balance sheet accounts are listed on this trial balance, they are presented in balance sheet order starting with assets, liabilities, and ending with equity.As with theunadjustedandadjusted trial balances, both the debit and credit columns are calculated at the bottom of a trial balance. If these columns aren't equal, the trial balance was prepared incorrectly or the closing entries weren't transferred to the ledger accounts accurately.As with allfinancial reports, trial balances are always prepared with a heading. Typically, the heading consists of three lines containing the company name, name of the trial balance, and date of the reporting period.

PreparationPosting accounts to the post closing trial balance follows the exact same procedures as preparing the other trial balances. Each account balance is transferred from the ledger accounts to the trial balance. All accounts with debit balances are listed on the left column and all accounts with credit balances are listed on the right column.The process is the same as the previous trial balances. Now the ledger accounts just have post closing entry totals.ExampleAfter Paul's Guitar Shop posted itsclosing journal entriesin the previous example, it can prepare this post closing trial balance.

Notice that this trial balance looks almost exactly like the Paul's balance sheet except in trial balance format. This is because onlybalance sheetaccounts are have balances after closing entries have been made.Now that the post closing trial balance is prepared and checked for errors, Paul can start recording any necessaryreversing entriesbefore the start of the next accounting period.

Reversing EntriesReversing entries, or reversing journal entries, are journal entries made at the beginning of an accounting period to reverse or cancel out adjusting journal entries made at the end of the previous accounting period. This is the last step in the accounting cycle. Reversing entries are made because previous year accruals and prepayments will be paid off or used during the new year and no longer need to be recorded as liabilities and assets. These entries are optional depending on whether or not there areadjusting journal entriesthat need to be reversed.Reversing entries are usually made to simplify bookkeeping in the new year. For example, if an accrued expense was recorded in the previous year, the bookkeeper or accountant can reverse this entry and account for the expense in the new year when it is paid. The reversing entry erases the prior year's accrual and the bookkeeper doesn't have to worry about it.If the bookkeeper doesn't reverse this accrual enter, he must remember the amount of expense that was previously recorded in the prior year's adjusting entry and only account for the new portion of the expenses incurred. He can't record the entire expense when it is paid because some of it was already recorded. He would be double counting the expense.ExampleIt might be helpful to look at the accounting for both situations to see how difficult bookkeeping can be without recording the reversing entries. Let's look at let's go back to youraccounting cycleexample of Paul's Guitar Shop.In December, Paul accrued $250 of wages payable for the half of his employee's pay period that was in December but wasn't paid until January. This end of the year adjusting journal entry looked like this:

Accounting with the reversing entry:Paul can reverse this wages accrual entry by debiting the wages payable account and crediting the wages expense account. This effectively cancels out the previous entry.

But wait, didn't we zero out the wages expense account in last year'sclosing entries? Yes, we did. This reversing entry actually puts a negative balance in the expense. You'll see why in a second.On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then record the payment by debiting the wages expense account for $500 and crediting the cash account for the same amount.Since the expense account had a negative balance of $250 in it from our reversing entry, the $500 payment entry will bring the balance up to positive $250-- in other words, the half of the wages that were incurred in January.

See how easy that is? Once the reversing entry is made, you can simply record the payment entry just like any other payment entry.Accounting without the reversing entry:If Paul does not reverse last year's accrual, he must keep track of the adjusting journal entry when it comes time to make his payments. Since half of the wages were expensed in December, Paul should only expense half of them in January.On January 7th, Paul pays his employee $500 for the two week pay period. He would debit wages expense for $250, debit wages payable for $250, and credit cash for $500.

The net effect of both journal entries have the same overall effect. Cash is decreased by $250. Wages payable is zeroed out and wages expense is increased by $250. Making the reversing entry at the beginning of the period just allows the accountant to forget about the adjusting journal entries made in the prior year and go on accounting for the current year like normal.

As you can see from theT-Accountsabove, both accounting method result in the same balances. The left set of T-Accounts are the accounting entries made with the reversing entry and the right T-Accounts are the entries made without the reversing entry.Recording reversing entries is the final step in theaccounting cycle. After these entries are made, the accountant can start the cycle over again with recordingjournal entries. This cycle repeats in the exact same format throughout the current year.