The Accounting Cycle

Accounting is basically an information system. Its primary objective is to collect and process relevant data in order to show the actual status of an enterprise in the form of financial statements. The information contained in the financial statements is then communicated or made available to all concerned external and internal parties who are the ultimate users of accounting information. The external users are people who are not directly involved in operating the business like company shareholders, creditors and lenders, the government, customers, external auditors, and investors.

The internal users of accounting information, on the other hand, are the people who are directly managing the business such as the officers of the company from the highest management people down to its sales staff. These external and internal users need the information generated by the accounting process so that they can make good decisions (Larson, Wild, and Chiappetta, 2005).

Accounting as a system involves a sequence of events which are repeated within a specified period called the accounting cycle. This cycle has ten primary steps, namely: identifying the transactions, analyzing the transactions, recording the transactions,  posting of transactions to the ledger, preparing the trial balance,  preparing the adjusting entries,   preparing the adjusted trial balance, preparing the financial statements, preparing the closing entries, and preparing the after-closing trial balance (QuickMBA, 2007).

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Identifying the transactions

The accounting cycle starts with the identification of events which could be considered valid transactions of the business. By valid transaction is meant any activity that could have an effect of either increasing or decreasing the holdings or properties of the business called its assets, the debts or obligations of the company called its liabilities, and the owner’s claim to the business or equity (Larson, Wild, and Chiappetta, 2005).

After all possible transactions have been identified the documents that would serve as evidence of the transactions, called the source documents, should be prepared. Examples of source documents are sales invoices which are issued to customers who purchase goods on credit and cash receipts which are issued for all cash received by the business (NetMBA, 2007).

Analyzing the transactions

This step involves the determination of the effect that transactions have on the business. Transactions could result to an increase in a company’s assets, decrease its liabilities, or increase or decrease the equity of the owner of the business. If the company, for instance, pays a supplier in cash, this particular transaction depletes the asset cash. A purchase of goods on credit, on the other hand, would increase the liabilities of the company, because it has to pay for it in the future. The particular accounts that would be affected by each transaction are therefore identified (NetMBA, 2007).

At this juncture, the company should now make a list of the accounts that it would be using in its accounting system. Called the chart of accounts, this list is prepared following the accepted accounting practice of allocating the account numbers 101 – 199 for asset accounts; 201 – 299 for liability accounts; 301 – 399 for equity accounts; 401 – 499 for revenue accounts; and 501 – 699 for the expense accounts (Larson, Wild, and Chiappetta, 2005).

Recording the transactions

After the transactions have been analyzed and the affected accounts identified, the transactions are recorded in a process called journalizing. This is done by making the necessary entries to the general journal where the transactions are recorded chronologically. Each entry should contain the following: the date the transaction was consummated; the accounts that affected by the transaction (note: for every transaction, there should always be a debit entry or entries and a credit entry or entries in equal amounts); the amount involved in the transaction; and the description of the transaction (Larson, Wild, and Chiappetta, 2005). 

Posting

 the entries found in the general journal should then be entered in the T-accounts found in the general ledger. This process is called posting. A general ledger is different from a general journal in the sense that while entries in the journal are in chronological order, entries in the ledger are grouped according to the accounts, i.e., asset accounts, followed by liability accounts, the owner’s equity accounts, the revenue accounts, and the expense accounts. After all the journal entries have been posted, the balances of the ledger accounts are taken (NetMBA, 2007).

Preparing the unadjusted trial balance

This step ensures that there is equality in all the debit and credit entries made during the recording process. The T-accounts are listed just as they are found in the general ledger, writing down all the debit balances under the left column and all the credit balances under the right column. According to the accounting rules, the total of the two columns should be equal. In case they are not, the error should be immediately located by doing the following: look for wrong postings (a debit balance might have been erroneously posted in the credit column); verify whether any ledger balance was not posted; see whether any wrong amount was posted; and check for double postings (NetMBA, 2007).

Preparing the adjusting entries

Transactions that extend beyond the accounting period should be put right by preparing the necessary adjusting entries. An example of such transactions concern prepaid expenses like prepaid rent and prepaid insurance. The amounts of rent and insurance that have actually been consumed during the period covered by the cycle should be deducted from the remaining prepaid amount. These adjusting entries are then journalized and posted to the ledger accounts (Larson, Wild, and Chiappetta, 2005).

Preparing the adjusted trial balance

Exactly the same procedure done when preparing the unadjusted trial balance is followed in this step. The difference between the two lies on the balances of accounts used. While unadjusted balances are used in preparing the unadjusted trial balance, the adjusted trial balance is prepared after the adjusting entries have been posted to the ledger accounts. The amounts shown in the adjusted trial balances are therefore already net of the adjustments made (Larson, Wild, and Chiappetta, 2005).

Preparing the financial statements

After the adjusted trial balance is prepared, the financial statements should now be prepared. The amounts used in these statements are the balances found in the adjusted trial balance. The accepted practice is for the income statement to be prepared first, followed by the statement of owner’s equity, and then the balance sheet.

The reason for this is simple: the net income reported by the income statement is used in completing the statement of owner’s equity. Then the balance sheet is prepared using balances found in the statement of owner’s equity. The last financial statement to be prepared is the statement of cash flow because it makes use of figures found in the other statements (Larson, Wild, and Chiappetta, 2005).

Preparing the closing entries

After all the financial statements have been completed, it is necessary to prepare the closing entries. This, in effect, takes care of the loose ends. Closing entries are important because of two considerations, namely: first, the expense, revenue, and withdrawal accounts should be closed because they have to have zero balances when the next accounting period begins; second, the balances of these accounts should be reflected in the owner’s equity account. This is done by using a temporary account called the income summary account.

The credit balances of the revenue accounts are transferred to the income summary account (debit revenue accounts, credit income summary), and then the debit balances of the expense accounts are also transferred to the income summary (debit income summary, credit expense accounts). The balance of the income summary account is then transferred to the owner’s equity. After this procedure, all the expense, revenue, withdrawal, as well as the income summary accounts should have zero balances (Larson, Wild, and Chiappetta, 2005).

Preparing the after-closing trial balance

The after-closing trial balance is much like the unadjusted and the adjusted trial balance. The difference is that the accounts contained in the after-closing trial balance are only permanent accounts because all the temporary accounts like the expense and the revenue accounts have already been closed. These permanent accounts are the items found in the asset, liability, and owner’s equity sections of the balance sheet of the company (Larson, Wild, and Chiappetta, 2005).

 References

1. Larson, K.D., Wild, J.J., & Chiappetta, B. (2005). Fundamental accounting principles (17^thed.). New York: McGraw-Hill Irwin.
2. NetMBA. (2007). The Accounting Process (The Accounting Cycle). Retrieved March 13, 2008 from http://www.netmba.com/accounting/fin/process/
3. QuickMBA. (2007). The Accounting Cycle. Retrieved March 13, 2008 from http://www.quickmba.com/accounting/fin/cycle/

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