Overview of the Accounting Cycle
©
2000 Terri L. Herron
Transactions are one type of business event.
Transactions may or may not necessitate an accounting entry to occur. Examples of transactions that do not require an accounting entry are placing an order with a vendor, hiring an employee, or changing an interest
rate. Examples of transactions that do require an accounting entry are receiving goods from a vendor, selling goods to
a customer, paying employees, and borrowing money. Notice that these accounting transactions focus on an exchange of economic
value between the
company and another party (vendor, customer, employee, creditor), and they will result in an update to the accounting records of a company.
To record accounting transactions, a series of steps are
followed. The accounting cycle is how transactions get reflected in the financial statements.
This accounting cycle typically goes as follows:
Recognize occurrence of
accounting transaction
Receive/create source
document
Record transaction in
general or special journal in chronological order (journalizing)
Post transactions to general
ledger from general and special journals (posting)
Post transactions to
applicable subsidiary ledgers from general and special journals (posting)
Determine balances in each
general ledger and subsidiary ledger account
Prepare pre-adjusting trial
balance
Prepare adjusting entries
and post these entries
Prepare post-adjusting trial
balance
Prepare financial statements
Close temporary accounts
(those on income statement and dividends)
Each accounting transaction should
be supported by proper documentation. This is a form of internal control to help ensure accurate accounting occurs.
Source documents contain information crucial to document that an exchange has occurred, including date, amount,
parties, and description of the transaction.
Often the terms of the transaction are included on the source document. Source documents can be generated by outside
parties (e.g., vendors, creditors, customers) or can be internally generated.
It is important that you understand the different types
of source documents and their purposes.
Source documents may exist in paper form or in electronic
form. Examples of source documents are:
Purchase requisition
Purchase order
Vendor invoice
Sales order
Sales invoice
Shipping advice/notice
Bill of lading
Receiving report
Check
Remittance advice
Deposit slip
Contract
Time card
Financial statements report a company’s (1) statement
of financial position and (2) results of operations. The statement of financial position or Balance Sheet is a
snapshot of the assets, liabilities, and equity at a single point in time. For that reason, the balance sheet is always “as
of” a certain date. The results of operations are reported in a variety of financial statements, each covering a period of
time. For that reason, financial statements depicting results of operations are “for the period ended” a certain date.
The income statement, statement of stockholders’ equity (or retained earnings), and statement of cash flows are the financial statements
reporting results of operations.
The accounting equation is:
Assets = Liabilities + Owners’ Equity. Recording of accounting transactions always affects one or more items
in the accounting equation, and after the transaction is recorded the accounting equation must still be in balance. The
challenge is recognizing which component(s) of the equation are affected by a transaction and how they are affected. For
example, if a company gets a loan at a bank, then assets (cash) increase and liabilities (loans payable) increase. Another
example is a customer paying off an outstanding balance due to the company. Here, assets (cash) increase and assets (accounts
receivable) decrease. In both examples, the accounting equation remains in balance.
Owners’ equity (or stockholders’ equity) is a very
important item to understand. Owners’ equity represents the owners’ claim to the net assets of the company (assets
minus liabilities) and is comprised of contributed capital and retained earnings. Owners’ equity increases when there is net
income or new issuances of stock. Owners’ equity decreases when there is net loss, payment of dividends to stockholders, or
repurchase of stock from stockholders (treasury stock).
The owners’ equity section of the balance sheet is the ending
position for that particular date. So any of the items that affect owners’ equity during the period should be reflected
in that number. Since owners’ equity is a function of net income(loss) and other transactions related to stock, the income
statement should be prepared first (to get the net income(loss) number), the statement of stockholders’ equity should be prepared second (to get the ending owners’
equity number), and the balance sheet should be prepared last.
The mechanics of reflecting accounting transactions in
the accounting records is accomplished through the use of the double-entry accounting system. All accounting systems,
manual or computerized, use the double-entry system. In the double-entry system, every journal entry will have the total
amount of the debits equal to the total amount of the credits.
A debit is an entry to the LEFT side of an account; a
credit is an entry to the RIGHT side of an account. The trick is recognizing when a debit increases or decreases an account
and when a credit increases or decreases an account. Here is the rule:
Items on the left side of the accounting equation are
increased with debits.
Items on the right side of the accounting equation are
increased with credits.
Assets = Liabilities + Owners’ Equity
Assets are increased (decreased) by debits (credits).
Liabilities are increased (decreased) by credits
(debits).
Owners’ equity is increased (decreased) by credits
(debits).
The more complex issue is how components of
owners’ equity are treated. Items that have an overall effect of increasing owners’ equity must be increased by credits. Items that
have an overall effect of decreasing owners’ equity must be increased by debits. If you interpret these transactions by
asking, “how should this affect owners’ equity?” then you will be better able to decide on whether you should make a debit or credit to the account.
Items increasing owners’ equity => increase with
credits
Ø Revenues
Ø Capital
stock
Ø Additional
paid-in capital
Items decreasing owners’ equity => increase with
debits
Ø Expenses
Ø Dividends
Certain "tools" are used to assist in the process in capturing the accounting effect of transactions (debits/credits) and then reflecting those effects in the financial statements. Journals and ledgers are two such tools.
A journal is a chronological listing of transactions.
The general journal is for listing anything not recorded in a special journal (discussed below). A general
journal entry (also called a journal entry) will contain one or more debits and one or more credits. The debits are listed to
the left; the credits are indented to the right. The journal entry is dated and a description included.
The following example shows how a journal entry would look to reflect cash received from a bank loan.
1/15/00 Cash 100,000
Loans Payable 100,000
(received proceeds from Bank ABC loan)
Special journals
are used for similar, repetitive transactions to save time and space in the journalizing and posting process. For example, a
cash receipts journal would have a column showing the amount of cash received, the amount to be applied to a customer account, and a column for entries to other accounts
besides cash and accounts receivable. When the cash receipts journal is posted, the cash received column is summed and posted
as a single debit to the cash account (rather than debits to cash for each receipt), the amounts applied to customer accounts are summed and posted as a single credit to
the accounts receivable account, and any other entries to other accounts are singularly posted to those respective accounts.
Other common special journals are the cash disbursements
journal, sales journal, purchases journal, and payroll journal. In a computerized environment, journals are maintained in
“transaction” files.
In computerized accounting systems, the use of journals may be transparent to the user. For example, instead of making entries to journals, the user may just complete fields on a computer screen. The underlying debits and credits are automatically generated and perhaps even automatically posted by the system.
Ledgers
While journals are chronologically listings of accounting
transactions (debits/credits), those transactions’ effects will not be reflected in the financial statements until they are
posted to the general ledger.
The general ledger contains all the accounts and their balances, regardless of which financial statement the accounts affect.
Posting is the process of transferring the debits and credits from the journals to the ledgers. So an entry
that increases cash (via a debit) has not actually increased the cash general ledger account until the journal entry has been posted to the general ledger.
Subsidiary ledgers
reflect the composition of some general ledger accounts. The most common accounts that have corresponding subsidiary ledgers
are accounts receivable, accounts payable, fixed assets, and inventory. A company can use a subsidiary ledger for any general
ledger account where a detailed decomposition of the account is needed to manage the business. Of course, the subsidiary
ledger balances should sum up to the corresponding account balances in the general ledger. For example, the total of all
customer balances outstanding in the accounts receivable subsidiary ledger should be the same amount as the balance in the accounts receivable
general ledger account as
of the same date. Since only the general ledger accounts are used to prepare financial statements, it is important to make
sure the subsidiary ledger balances are reconciled to the general ledger before preparing financial statements.
Finally, recognize that when subsidiary ledgers are used,
debits or credits affecting those records must be posted twice: once to the general ledger and once to the subsidiary ledger.
So the double-entry rule of total debits equaling total credits is applied only at the general ledger level. Also, the
general ledger account (e.g., accounts receivable) is also referred to as the “control” account, while each account in the subsidiary ledger (e.g., Customer ABC) is
referred to as the “sub” account.
In a computerized environment, both the general ledger
and subsidiary ledger are maintained in “master” files.
Trial balances
are another "tool" used in accounting.
Trial balances are listings of all the general ledger
accounts and their respective balances. The purposes of the trial balance
are to (1) prove that debits equal credits and (2) review
the accounts and their balances to see if any obvious
errors exist.
Trial balances can be in their more traditional format of debits in one column and credits in another column or in an alternative format of all balances listed in
one column with credits shown as negative/bracketed numbers. Preparing a trial balance will not easily discover any accounting errors that do not affect debits and credits
differentially. For example, debiting the wrong account but using the correct amount will not cause the trial balance to be
out of balance.
Besides checking for balance between debits and credits,
the trial balance can be used to prepare adjusting entries (discussed below) or even to prepare financial statements once the balances are properly adjusted.
A trial balance can be prepared at any point in the accounting cycle or fiscal year. It is an internal tool that is
not a financial statement. The accounts are grouped by financial statement, with balance sheet accounts listed first, and
then in the order they would appear on the respective financial statement.
While certain events give rise to accounting transactions throughout the period, certain accounting transactions need to be recorded in different periods than the event period, or they need to be recorded over a series of periods. The reason adjusting entries are necessary is that some events affect more than one period, and the accrual basis of accounting is founded on the “matching” principle.
The matching principle says that revenues and related expenses should be recorded in the same
period, regardless of when the cash changes hands. For example, if a company buys a machine with a useful life of five years,
then the cost of that machine should be allocated amongst all five of those
years because the machine benefits the company in those
years. In this example, there is not an event in
year 2 that triggers the recording of depreciation (the allocation of the cost of the asset), so it is accomplished by making an adjusting entry.
Adjusting entries need only be recorded immediately prior
to preparing financial statements or internal reports that they may affect. This is typically done on a monthly basis via
general journal entries. Remember that all adjusting entries should be reflected in any corresponding subsidiary ledgers.
Computerized accounting systems will often have the capability to have certain adjusting entries set up in advance, to be calculated, made and posted with few keystrokes at the time financial statements are prepared (e.g., depreciation).
While all general ledger accounts have running balances
(net of all debits and credits), some accounts should be set back to zero at the start of each major accounting period (usually annually).
It is akin to resetting your tripometer in your car after you fill it up with gas – you want to start over in your count of how many miles you travel.
This is called closing the accounts and is accomplished by closing entries. Accounts that should be closed are called
“temporary” or “nominal” accounts and include the accounts that report results of operation. This would be all
accounts reflected on the income statement, as well as the dividends account. Balance sheet accounts are never closed.
After closing entries, the balance in the retained earnings account will reflect all past periods' impacts (revenues, expenses, and dividends).
Computerized accounting systems will usually have a command or routine that the user can execute that automatically closes the accounts when a new accounting period is ready to begin.
While the accounting cycle refers to the process followed
to reflect accounting transactions in the financial statements, transaction cycles are business events grouped together for convenience purposes based on their
common purpose or use of data. Transaction cycles can be created for any groups of events, but the most common cycles (broken
out into common sub-cycles) are:
Ø Revenue
cycle
o Sales
cycle
o Cash
receipts cycle
Ø Expenditure
cycle
o Purchases
cycle
o Cash
disbursements cycle
Ø Resource
management cycle
o Inventory
cycle
o Fixed
assets cycle
o Payroll
cycle
o Owners’
equity cycle
Ø Reporting
cycle
Accounting software is typically organized around
transaction cycles. For example, a set of menus for Sales would include the ability to record a customer order, invoice a
customer and record shipment, record the cash received from a customer, record merchandise returned by a customer, and add/delete/change customer information.
Some accounting software also includes the capability to integrate accounting features with other business processes (e.g., customer service, production
management).
Nearly all entities use some form of computerized
accounting application. This allows the computer to do all the mechanical processes inherent in accounting. The computer performs
computations, creates all or part of journal entries, posts entries to general ledger and subsidiary ledger accounts, carries out various controls, and allows for storage
of large amounts of data that is easily and quickly accessed by users.
One misnomer about accounting software applications is
that they do not follow the double-entry accounting method. This is not true! All
computerized accounting applications use double-entry accounting. However, the user may not be able to easily “see”
all components of entries related to a transaction. For example, when cash is received from a customer, the user may enter
the date, customer, amount, and applicable invoice to which the collection relates. Then the computer updates the customer
account (via credit), the accounts receivable account in the general ledger (via credit), and the cash account in the general ledger (via debit).
Transactions may be processed either in batch mode or
online (real time) mode. In batch processing, the transactions are accumulated and entered all at one time in a “batch.” Batches may be processed as infrequently as monthly or as frequently as several times daily. In batch
processing the accounts are only truly current immediately after processing the batch. The other processing alternative is
online processing, where transactions are reflected in the accounts as the data is captured in the computer system. For
example, if a shipment is made to a customer, inventory would be immediately reduced and the customer account immediately increased. Corresponding
income statement accounts would also be updated to reflect the transaction. In online processing mode a query of an account
would reflect the correct balance at any time.
How do you know if a routine is a batch or online
routine? If you need to instruct the computer to
periodically update or post to accounts some time after
the information is initially entered into the system, then that routine uses batch processing.
If the computer automatically and immediately does the update, then that routine uses online processing. Note that an
accounting package can use a mixture of batch and online processing. For example, sales can be recorded in batch mode while
maintenance of customer accounts (name, address, credit limit, etc.) can be done online.