What is the Accounting Cycle?

what-is-the-accounting-cycle

The accounting cycle of steps that occur during a business cycle to record the economic activities of a company for the period.

Accounting Cycle Steps

There are several steps from the recording of financial transactions to constructing the financial statements (each step is explained in more detail below):

– recording the transaction in a journal entry
– posting the journal entry to a log called ‘the journal’
– updating ‘the ledger’ which holds all T-accounts to reflect the newly posted journal entry
– at year’s end, adjusting entries are made
– at year’s end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero
– at year’s end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet


Record Journal Entries

As discussed above, transactions are recorded on T-accounts that are impacted by the transaction. For example, when a firm pays the electricity bill, the T-accounts cash and electricity expenses need to be updated with the amount paid.

Not all transactions are recorded. Usually when parties come to an agreement, but neither party performs their part of the deal, no transaction is recorded. For example, a customer places an order (which is legally binding), but does not pay yet. Also, the firm has not made a delivery. Only if at least one party delivers (either the customer pays, or the firm makes a delivery), a journal entry is made.

For accounting purposes, a transaction can also be the mere passing of time. Consider for example the effect of time on the value of a loan. A loan that is interest bearing will increase when time passes by. Journal entries that are made at year’s end to update the financial statements are called ‘end of year adjusting entries’.


Post Journal Entries

The ‘journal’ is a list of all journal entries that were made (in chronological order). It is used as a reference so that at a later point in time people can easily see which journal entries were made on a specific date. It is not helpful in constructing the actual values of T-accounts, as you will need to work through the whole journal to collect all entries to some T-account. For this purpose, the ledger is used (discussed next).


Update Ledger with T-Accounts

The ‘ledger’ is a collection of all T-accounts and contains all the changes to these T-accounts. So, if you want to verify whether or not the actual amount of cash equals the amount of cash in the books, it can easily be determined by accessing the T-account cash from the ledger. This T-account will show all transactions involving the receipt or payment of cash and will show the balance.

Tax authorities require firms to keep several years of history of the ledger. With the ledger, the tax authorities can easily verify whether or not the firm has correctly applied fiscal law in the audited years.


Record Adjusting Journal Entries

At year’s end, it is common that assets and liabilities need to be adjusted. For example, the firm has long term assets that gradually reduce in value. So, at year’s end, the decline in value for the period needs to be accounted for. Also, the liabilities may have changed. For example, over time, interest accrues on interest bearing liabilities.

The adjustments are booked with a journal entry and posted to the journal, just as any other transaction.


Close Temporary Accounts

-at year’s end, temporary T-accounts are used to construct the income statement, which is added to retained earnings, and dividends declared are subtracted from retained earnings; in this step all temporary T-accounts are reset to zero

In the process of making the financial statements, a list of all T-accounts with their balances is constructed, which is called the ‘trial balance’. It is important to realize that the trial balance is not a balance sheet, but rather a list of temporary T-accounts (expenses and revenues and dividends declared) as well as permanent T-accounts (assets, liabilities and equity).

The temporary T-accounts related to expenses and revenues are used to make the income statement, where net income equals total revenues minus total expenses.

As the trial balance is balanced (total debits equal total credits), net income is implicitly included twice in the trial balance. First, it is the balance of the temporary T-accounts. In case of a profit, the net balance of the temporary T-accounts will be a credit balance. Second, net income will be the net balance of the permanent T-accounts. In case of a profit, assets will have a higher balance than liabilities and equity. When temporary T-accounts are used, revenues and expenses were no longer added to retained earnings. In other words, net income needs to be added to retained earnings to have a balanced balance sheet.

When net income is know, the statement of retained earnings can be computed. During the year, all changes in retained earnings are booked on temporary T-accounts. Thus, retained earnings is not used during the year. Hence, the balance of this T-account on the trial balance will be last year’s ending balance. So, at year’s end this T-account needs to be updated. Retained earnings increases with net income of the year, and decreases with dividends declared. This step is performed by making a journal entry which resets all temporary T-accounts to zero, and transferring the balance to retained earnings.


Accounting Cycle Example

Consider the following trial balance:

T-account Debit Credit
Sales 100
Wages expense 50
Rental expense 30
Dividend declared 15
Cash 30
Accounts receivable 100
Real estate 150
Paid-in capital 20
Retained earnings 50
Bank loan 200
Interest payable 5
Totals 375 375

the journal entry to ‘close the books’ is the following:

T-account Debit Credit
Sales 100
Wages expense 50
Rental expense 30
Dividend declared 15
Retained earnings 5

Notice that all temporary T-accounts will have zero balances as a result of this entry. Even though net income is 20 (=100 – 50 – 30), retained earnings will increase by 5, as during the year 15 had been paid out as a dividend.

It is also possible to use an additional temporary T-account ‘Profit summary’. In this case, first all temporary T-accounts are cleared against this T-account (and not retained earnings). As a second step, the profit summary is added to retained earnings. The ending balance of retained earnings is the same for either method.


Create Financial Statements

-at year’s end, the permanent T-accounts (included the updated retained earnings) are used to construct the balance sheet

When the statement of retained earnings is made, construction of the balance sheet is straightforward. All permanent T-accounts (and their balances) are taken from the trial balance, while using the updated value for the balance of retained earnings. This will result in a balance sheet where total debits equal total credits.


Accounting Cycle Explained

Key points:

– journal entry are posted to the journal, which is a log with all journal entries made in  chronological order

– the ledger is the collection of all T-accounts and all debits and credits to these T-accounts

– at year’s end, adjusting entries are needed to make sure all assets and liabilities are included for the correct amounts

– the trial balance is a list of all T-accounts (whether temporary, or permanent) and their balances, where the total of all debit balances equal the total of all credit balances

– in the trial balance, the balance of retained earnings will be last year’s balance, as retained earnings is not used during the year (instead during the year temporary T-accounts are used for expenses, revenues and dividends)

– after ‘closing the books’, retained earnings increases with net income, and decreases with dividends

– the income statement is showing revenues minus expenses (which are temporary T-accounts)

– the statement of retained earnings shows the beginning balance of retained earnings to which net income is added and dividends are subtracted, resulting in the end of year retained earnings

– the balance sheet shows the balances of all permanent T-accounts


Comprehensive example: From transactions to financial statements

This section extends the example introduced in Financial statements: Using the accounting equation to record transactions. For these transactions, journal entries are made and entered into the journal, updating the ledger, etcetera, resulting in the financial statements. This example does not include adjusting entries. Examples on adjusting entries are included in the next lesson accrual accounting.

Work through the interactive example below:

– On tab ‘transactions’ the transactions are listed, where for each transaction the effect on the accounting equation is shown, as well as the journal entry. Clicking on the T-account in the journal entry shows the debit-and-credit rules for that T-account.

– On tab ‘browse’ the trial balance is shown. When clicking on a T-account, the transactions recorded in the T-account are listed. When clicking on a transaction, the underlying journal entry is presented.

– On tab ‘statements’ three financial statements are shown: the income statement, the statement of retained earnings and the balance sheet.

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