The Accounting Cycle

Lesson One: Accounting Cycle (this lesson)Lesson Two: Basic Accounting Journal Entries Lesson Three: Accounting Journals Lesson Four: T Accounts Lesson Five: Balancing T-accounts Lesson Six: Posting Journals Lesson Seven: Control Accounts Lesson Eight: Trial Balance

There is a cycle of action in accounting for any business. This cycle is depicted diagrammatically below:

1. SOURCE DOCUMENTS – Source documents are documents, such as cash slips, invoices, etc. that form the source of (and serve as proof for) a transaction. In other words, they are the first documents that exist relating to a transaction.

Invoices, cash slips, receipts, check counterfoils, bank deposit slips and even internet payment confirmations are all source documents.

Example:On 01-01-2012 Uttara Store had the Following account balances: Cash and Bank Tk 300,000 Furniture Tk 50,000. Accumulated Depreciation on Furniture Tk 10,000. Inventory Tk 4,000. During 2012 the Following Transactions took place,

(1) PurchasesTk 2,50,000 (on credit Tk 50,000)(2) Sales Tk 4,00,000 (on credit Tk 60,000)(3) Salaries paid Tk 50,000(4) Mise expenses Tk 40,000

Information for adjustments:(1) Inventory on 31-12-2012 Tk 6,000(2) Depreciation on furniture 5,000(3) Provide allowance for doubtful accounts at 2% on Account

receivable(4) Salaries prepaid Tk 2,000

2. JOURNALS - These are chronological (date-order) records of transactions entered into by a business. Journals are that first basic entry of debit and credit for each transaction. In the examples we have been doing in the previous chapters, where we have debited one account and credited another, we have been doing journals

General Journal entry Page no:-1Dates Accout Titles Post

Ref.Debits Credits

2009 CashFurniturInventory Accumulated Depreciation Capital(For investmant in the Bussiness)

101102103201301

300,000 50,000 4000

10,000344,000

Jan

1

jan

1 Purchase Cash Accout Payable(For Purchase cash and account)

501101202

250,000200,000 50,000

jan

2 Cash Account Receivable Sales(For sales cash and account)

101104401

340,000 60,000

400,000

Jan

3 Salaries Expense Cash (For salaries expense paid in cash)

502101

50,000 50,000

Jan

4 Miscellaneous Expense Cash(For miscellaneous expense pain in cash)

503101

40,000 40,000

3. LEDGER (T-ACCOUNTS) - The ledger is a collective term for the accounts of a business. (A ledger of accounts is like a school of fish). The

accounts are in the shape of a ‘T’ and thus are often referred to as ‘T-accounts’. In this step we take all the debits and credits (journals) relating to one account – let’s say ‘bank’ – and draw up an account for bank that

shows all the transactions relating to it.

General ledger

Cash account no. 101Dates Explanation P:R Debit Credit Balance2009 Capital

PurchaseSalesSalariesMisllaneous

Gj.1Gj1Gj1Gj1Gj1

300,000

340,000200,000

50,000 40,000

300,000100,000440,000390,000350,000

Jan 1234

Furnitur account no. 102Dates Explanation P:R Debit Credit Balance2009 Capital Gj.1 50,000 50,000

Jan 1

Inventory account no. 103Dates Explanation P:R Debit Credit Balance2009 Capital Gj.1 40,000 40,000

Jan 1

Accumulated Depreciation Account no. 201Dates Explanation P:R Debit Credit Balance2009 Furnitur Gj.1 10,000 10,000

Jan 1

Capital Account no. 301Dates Explanation P:R Debit Credit Balance2009 Sundry

AssetsGj.1 344,000 344,000

Jan 1

purchase Account no. 501Dates Explanation P:R Debit Credit Balance2009 Cash

Account Payable

Gj.1Gj1

200,000 50,000

200,000250,000Jan

Jan11

Sales account no. 301Dates Explanation P:R Debit Credit Balance2009 Cash

Account Receivable

Gj.1Gj1

340,000 60,000

340,000400,000Jan 1

Account Payable account no. 401Dates Explanation P:R Debit Credit Balance2009 Purchase Gj.1 50,000 50,000

Jan 2

Account Receivable account no. 104Dates Explanation P:R Debit Credit Balance2009 sales Gj.1 60,000 60,000

Jan 2

Salaries account no. 502Dates Explanation P:R Debit Credit Balance2009 Cash Gj.1 50,000 50,000

Jan 3

Miscellaneous account no. 503Dates Explanation P:R Debit Credit Balance2009 Cash Gj.1 40,000 40,000

Jan 4

4. TRIAL BALANCE - A sheet displaying all the accounts of a business, drawn up as a trial (test) of whether the total of all the debit

balances equal the total of all the credit balances (A balance is the amount of an item at a point in time. For example, The balance in the bank account on the 1st of January was $5,000.). The trial balance is

prepared as a final check just before the financial statements are drawn up. Click here for a brief lesson on the trial balance.

Trial BalanceJanuary 31, 2009

Account no Explanation Post Ref. Debit Credit

101102103201301501401202104502503

CashFurniturInventoryAccumulation Dep.CapitalPurchaseSalesAccount PayableAccount ReceivableSalaries expenseMiscellaneous Total

350,000 50,000 4,000

250,000

60,000 50,000 40,000

10,000344,000

400,000 50,000

804,000 804,000

Account: noA 1L 2C 3l 4E 5

Adjustting Entries

Dates Explanation P,Ref. Debit Credit1 Income Summery

Opening Inventory(To record opening inventor adjusted the income summery)

402103

4,0004,000

2 Closing Inventory Income Summery(To record closig inventory adjusted the income summery)

102402

6,0006,000

3 Depreceation on Furnitur Accumulated Depreciation on Furnitur(To record Depreciation and Accumulated depriation adjusted)

504 5,0005,000

4 Uncollectible expense 505 1,200

Allowance for doutedful account(To record uncollectible expense adjusted0

203 1,200

5 Prepaid Salaries Salaries Expense(To record prepaid salaries adjusted)

104502

2,0002,000

Work Sheet

For the year Ended 31st December 2012Explanation Trial

BalanceAdjustment Adjusted

Triel Balance

Income Statement

Balance Sheet

Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.cashFurniturinvetoryAccu.Dep.

Prepare the financial statements.

o Income statement: prepared from the revenue, expenses, gains, and losses.

o Balance sheet: prepared from the assets, liabilities, and equity accounts.

o Statement of retained earnings: prepared from net income and dividend information.

o Cash flow statement: derived from the other financial statements using either the direct or indirect method.

Income StatementFor the year ended 31th December 2012

Explanation Tk Tk Tk SalesLess cost of good Sold: Opening Inventory Parchase

Less closing Inventory

Gross ProfitLess Operating Expense: Salaries Expensa Un Collectible Expense

Adminestrative Expense Depreciation Expense Miscellaneous Expense

Total Expense Net profit

48,000 1,200

4,0002,50,000

400,000

(2,48,000)

2,54,000 6,000

49,200

45,000

1,52,000

(94,200)

5,000 40,000

57,800

Balance SheetFor the year ended 31th December 2012

Explanation Tk Tk Assets Cash Account Receivable Less Allowance for doubtful account

Closing Inventory Prepaid salaries Furnitur Less Accumulated Deprciation Total Assets

Liabilities Accumulated Depreciation Capital Add Net Profit Total Liabilities and owner’s Equity

60,000 1,200

3,50,000

58,800 6,000 2,000

35,000

50,000 15,000

3,44,000 57,800

4,51,800

50,000

4,01,8004,51,800

Closing Entries

Date Explanation P:R Debit CreditIncome Summary Opening Inventory

402103

103402401402402501502504505503402301

4,000

6,000

400,000

344,200

57,800

4,000

6,000

400,000

25,000 48,000 5,000 1,200 40,000

57,800

Closing Inventory Income SummarySales Income SummaryIncome Summary Purchase Salaries Depreciation Uncallectible Expense Misscellaneous ExpenseIncome Summary Capital

Post-Closing Trial Balance

Acct: no

Explanation P:R Debit Credit

101102104203104202201301103

CashFurniturePrepaid SalariesAllowance for doubtful Acct:Account ReceivableAccount PayableAccumuladed dep. On FurnitureCapitalInventory Total

350,000 50,000 2,000

6,000

6,000

1,200

50,000 15,000401,800

468,000 468,000

Major Steps in Accounting Cycle

Following are the major steps involved in the accounting cycle. We will use a simple example problem to explain each step.

1. Analyzing and recording transactions via journal entries2. Posting journal entries to ledger accounts3. Preparing unadjusted trial balance4. Preparing adjusting entries at the end of the period5. Preparing adjusted trial balance6. Preparing financial statements7. Closing temporary accounts via closing entries8. Preparing post-closing trial balance

Flow Chart

The Accounting Process(The Accounting Cycle)

The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps:

2. Identify the transaction or other recognizable event.3. Prepare the transaction's source document such as a purchase order or invoice.

4. Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected and whether those accounts are to be debited or credited.

5. Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order.

6. Post general journal entries to the ledger accounts.

__________________

The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period:

7. Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance.

8. Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:

o posting of the wrong amount,o omitting a posting,o posting in the wrong column, oro posting more than once.

9. Prepare adjusting entries to record accrued, deferred, and estimated amounts.10. Post adjusting entries to the ledger accounts.

11. Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.

12. Prepare the financial statements.

o Income statement: prepared from the revenue, expenses, gains, and losses.

o Balance sheet: prepared from the assets, liabilities, and equity accounts.

o Statement of retained earnings: prepared from net income and dividend information.

o Cash flow statement: derived from the other financial statements using either the direct or indirect method.

13. Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital.

14. Post closing entries to the ledger accounts.

15. Prepare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors.

16. Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period.

Instead of preparing the financial statements before the closing journal entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.

Accounting Cycle Steps

1. Identifying and Analyzing Business Transactions

The accounting process starts with identifying and analyzing business transactions and events. Not all transactions and events are entered into the accounting system. Only those that pertain to the business entity are included in the process.

For example, a loan made by the owner in his name that does not have anything to do with the entity is not accounted for.

The transactions identified are then analyzed to determine the accounts affected and the amounts to be recorded.

The first step includes the preparation of business documents, or source documents. A business document serves as basis for recording a transaction.

2. Recording in the Journals

A journal is a book – paper or electronic – in which transactions are recorded. Business transactions are recorded using the double-entry bookkeeping system. They are recorded in journal entries containing at least two accounts (one debited and one credited).

To simplify the recording process, special journals are often used for transactions that recur frequently such as sales, purchases, cash receipts, and cash disbursements. A general journal is used to record those that cannot be entered in the special books.

Transactions are recorded in chronological order and as they occur. Hence, journals are also known as Books of Original Entry.

3. Posting to the Ledger

Also known as Books of Final Entry, a ledger is a collection of accounts that shows the changes made to each account as a result of past transactions, and their current balances. This is the core of the classifying phase.

After the posting process, the balances of each account can now be determined.

For example, all journal entries made to Cash would be transferred into the Cash account in the ledger. Increases and decreases in cash will be entered into one ledger account. Thus, the ending balance of Cash can be determined.

4. Unadjusted Trial Balance

A trial balance is prepared to test the equality of the debits and credits. All account balances are extracted from the ledger and arranged in one report. Afterwards, all debit balances are added. All credit balances are also added. Total debits should be equal to total credits.

When errors are discovered, correcting entries are made to rectify them or reverse their effect. Take note however that the purpose of a trial balance is only test the equality of total debits and total credits and not to determine the correctness of accounting records.

Some errors could exist even if debits are equal to credits, such as double posting or failure to record a transaction.

5. Adjusting Entries

Adjusting entries are prepared as an application of the accrual basis of accounting. At the end of the accounting period, some expenses may have been incurred but not yet recorded in the journals. Some income may have been earned but not entered in the books.

Adjusting entries are prepared to have the accounts updated before they are summarized into the financial statements.

Adjusting entries are made for accrual of income, accrual of expenses, deferrals (income method or liability method), prepayments (asset method or expense method), depreciation, and allowances.

6. Adjusted Trial Balance

An adjusted trial balance may be prepared after adjusting entries are made and before the financial statements are prepared. This is to test if the debits are equal to credits after adjusting entries are made.

7. Financial Statements

When the accounts are already up-to-date and equality between the debits and credits have been tested, the financial statements can now be prepared. The financial statements are the end-products of an accounting system.

A complete set of financial statements is made up of: (1) Statement of Comprehensive Income (Income Statement and Other Comprehensive Income), (2) Statement of Changes in Equity, (3) Statement of Financial Position or Balance Sheet, (4) Statement of Cash Flows, and (5) Notes to Financial Statements.

8. Closing Entries

Temporary or nominal accounts, i.e. income statement accounts, are closed to prepare the system for the next accounting period. Temporary accounts include income, expense, and withdrawal accounts. These items are measured periodically.

The accounts are closed to a summary account (often, Income Summary) and then closed further to the appropriate capital account. Take note that closing entries are made only for temporary accounts. Real or permanent accounts, i.e. balance sheet accounts, are not closed.

9. Post-Closing Trial Balance

In the accounting cycle, the last step is to prepare a post-closing trial balance. It is prepared to test the equality of debits and credits after closing entries are made. Since temporary accounts are already closed at this point, the post-closing trial balance contains real accounts only.