Accounting Cycle

Accounting cycle is a step-by-step process of recording, classification and summarization of economic

transactions of a business. It generates useful financial information in the form of financial
statements including income statement, balance sheet, cash flow statement and statement of changes
in equity.
The time period principle requires that a business should prepare its financial statements on periodic
basis. Therefore accounting cycle is followed once during each accounting period. Accounting Cycle
starts from the recording of individual transactions and ends on the preparation of financial statements
and closing entries.

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.
2.
3.
4.
5.
6.
7.
8.

Analyzing and recording transactions via journal entries

Posting journal entries to ledger accounts
Preparing unadjusted trial balance
Preparing adjusting entries at the end of the period
Preparing adjusted trial balance
Preparing financial statements
Closing temporary accounts via closing entries
Preparing post-closing trial balance

Flow Chart

Steps in the Accounting Cycle

There are ten basic steps to the accounting cycle.
1. Collect source documents
The very first step in the accounting cycle is to gather all the documents that are related to financial
transactions of the organization. These documents, called source documents, are things like
receipts, bank statements, checks, and purchase orders. They are the items that describe what a
transaction was for.

2. Analyze transactions
The second step in the accounting cycle is to analyze the source documents. The purpose of this is
to look them over and then decide what effect they have had on company accounts.
3. Journalize transactions
The third step in the accounting cycle is to post entries into the journal for the analyzed transactions.
A journal is the book or electronic record that documents all the financial transactions for a company
and the accounts that are affected by each transaction. When a journal entry is made, the 'doubleentry' rule is used. This means that for every one transaction, at least two accounts are affected.
There must be a debit and a credit for each transaction, and the total of debits and credits must
equal the amount of the transaction. Journal entries are entered in chronological order, and debits
are entered before credits.

4. Post transactions
The fourth step in the accounting cycle is to transfer information from the journal to the ledger. A
ledger is a book or an electronic record of all the accounts that a company has. These accounts are
broken down by account number and class. When the information from the journal is transferred to
the ledger, it is transferred to each account that was affected by a transaction.
5. Prepare an unadjusted trial balance
A trial balance is a list of all the company's accounts and their balance at the time the trial balance is
prepared. An unadjusted trial balance is a trial balance that is prepared before adjusting entries are

made into accounts. This information comes directly from the ledger. The total debit balance and
total credit balance must be equal.
6. Prepare adjusting entries
Adjusting entries are entries that are made in the journal and posted in the ledger. The purpose of
these entries is to bring account balances to the proper amounts. Not all accounts will have an
adjusting entry. Adjusting entries are made at the end of the accounting period but not the end of the
accounting cycle.
7. Prepare trial balance
Remember, the trial balance is a list of all accounts and their balances after adjustments have been
made. This trial balance is prepared to check and make sure that debits and credits equal after
adjusting entries are made. It is used to prepare the financial statements.
8. Prepare financial statements
These are prepared in a specific order because information from one financial statement is often
used in preparing another financial statement.

What Is Accounting?
Charlie has just opened his own hardware store. Even though he knows the basics of business
management, he has no idea how to keep financial records. He decides to take a crash course in
accounting.
Charlie walks into class on day one prepared to conquer accounting. The first thing that he notices
when he walks in the room is three questions written on the board. The first question asks what
accounting is and what its purpose is. The second asks how accounting is important. The last
question asks how accounting relates to business.
'Well,' Charlie says to himself, 'if I knew that I wouldn't be here.'
Soon, a rather burly-looking old fellow comes in and leans on the podium. 'Good morning class. I am
Professor Potter. How many of you can answer the questions I have on the board?' The room is
silent. 'Well, then, I guess we have quite a bit to talk about. I can't promise miracles, but I can
promise you that before you leave this room today, you will know the answer to all three questions!'
Professor Potter points to the first question. Speaking loudly, he says, 'What is accounting? I know
that you have all heard it before. So, tell me what the word 'accounting' means to you.' Pointing at

Charlie, Professor Potter says, 'Go ahead, young man. I'm sure that you can give me some kind of
answer.'
Charlie smiles and replies, 'Accounting is just a bunch of numbers that get added or subtracted,
depending on if you are making money or paying bills.'
'Not a bad answer,' Professor Potter says, 'but accounting is really much more than that. The
textbook definition of accounting is that it is the act of collecting, organizing. and interpreting
financial data. In a nutshell, that's true. However, to fully understand the entire concept of accounting,
there are a few more things that we need to discuss.'

Basic Accounting Equation

'How many of you know what aloe is?' Professor Potter asks. Several people raise their hands. 'I see
that there are a lot of you that know what aloe is. Is aloe the stuff that you can put on a burn to make
it feel better?' Professor Potter sees several heads bobbing in agreement. 'That's true; aloe is a plant
that is used to relieve the pain of burns. But, did you know that aloe has a place in accounting, too?'
Looking around, Professor Potter sees a room full of questioning faces.
He takes a piece of chalk and writes the word 'ALOE' on the board. 'A-L-O-E, class, is an acronym for
the most important piece of the accounting puzzle. ALOE stands for assets, liabilities, and owner's
equity. These are the components of the basic accounting equation: assets = liabilities + owner's
equity.'
'Now that you know what ALOE represents, let's talk about what each term means. Assets are items
that are owned, have value, and can be turned into cash. Bank accounts, CDs, cars, property, and
machinery are all examples of assets. Liabilities are what is owed. A loan to purchase an asset is a
liability. Owner's equity is the amount of money that a person has invested into an organization. The
investment may be in the form of a stock purchase or a capital investment made by buying into a
company. The most important thing to remember is that both sides of the accounting equation must
be equal. If they don't balance, then there is a problem.'
'Let me see if I understand this correctly, Professor Potter,' Charlie says. 'I am opening up a
hardware store in a building that I inherited. I know that I have to have $30,000 to purchase
inventory, $15,000 to purchase shelving, and an additional $10,000 in the bank for beginning
operating costs. I had $20,000 of my own money saved, and I borrowed $35,000 from the bank. If
I'm looking at this correctly, then my assets are the $30,000 in inventory plus the $15,000 in shelves I
bought and installed plus the $10,000 that's in cash that is in the bank for beginning operations. That
means my total assets are $55,000. I borrowed $35,000 to get the store going, so that's what I owe,
which is a liability. The $20,000 is what I personally invested in the business, so that is my owner's

equity. My assets equal $55,000, and the sum of my liabilities and owner's equity equals $55,000.
Both sides of the accounting equation are equal. So, I balance.'
'You've got it, Charlie,' Professor Potter says. 'Does everyone understand the basic accounting
equation?' The entire class nods their heads. 'Excellent, then we can move on.'

Purpose of Accounting
'Now that you know what ALOE is in accounting, let's talk about the entire purpose of accounting.
Can anyone guess what the main purpose of accounting is?' Professor Potter asks.
Charlie, feeling rather confidant since he has mastered the ALOE concept, decides he will respond
to Professor Potter. 'It seems to me that the purpose of accounting is so that a business knows how
to classify its expenses,' he says.
'You are on the right track, Charlie,' Professor Potter says. 'But, let me explain this a bit further.
Though there are many reasons why companies use accounting, the main reason is to be able to
produce financial statements. In order to produce the financial statements, all the income and
expenses of the company must be collected, classified, and entered into special accounting books
called journals. Accounting is a step-by-step process that follows a specific pattern. The pattern
resembles a circle and is called the accounting cycle. The accounting cycle usually takes 12
months to complete, but that's not set in stone. A company can choose how long it wants its
accounting cycle to be. Regardless of how long the accounting cycle is, one of the last steps in it is
creating the financial statements.'

Importance of Accounting
'Since I just told you what the purpose of accounting was, let's talk about why it's important. Do you
remember being a child, and it seemed that as soon as you were given money it was gone?'
Professor Potter asks.
Looking around the room, he can tell by the smiles that everyone in the class remembers that time in
their lives. 'Now, can you imagine how well a company could run if they had no idea where their
money went? I feel safe in predicting that the majority of companies out there would be in ruins and
so would the entire economy. In order to even have a hope of success, a company has to know
where their money is coming from and where it's going out. That's the importance of accounting and
of the financial statements.'

Charlie is curious. He has heard the term 'financial statements' before, but he really doesn't know
what they are. 'Excuse me, Professor Potter,' Charlie says, 'I really don't know what financial
statements are. Can you explain them?'
'Charlie, good man, I am so glad that you asked. There are four main financial statements that are
created in the accounting cycle. And just so you know, they are created in a specific pattern. The first
financial statement is the income statement, which tells how much money was made or lost in a
given time period. Next is the statement of retained earnings, which tells how much money that
was made was reinvested into the company. The third statement is the balance sheet. The balance
sheet is the financial statement that lists all the assets, liabilities, and owner's equity of the company.
It's important to note here that the accounting equation is also known as the balance sheet equation.
The last financial statement is the statement of cash flows, which tells how much money came in
and was paid out in a specific time period.'

Accounting has many uses. In this lesson, you will learn not only who accounting users are but also
what types of accounting information is used. You will also learn the uses of that accounting
information.

Which Is Which?
Sam and Sally are cousins. Sam works as a loan officer at a bank. Sally owns her own bakery. Sally
decides to ask Sam for a loan to expand her business.
Both Sam and Sally are users of accounting information. One of them is an external user, and one is
an internal user. Do you know which is which? You may not yet, but before this lesson is over, you
will know not only which one is what type of user, but you will also learn what the uses of accounting
information are.

External Users of Accounting Information

External - what does that mean to you? When I think of something that is external, I think of
something that is outside. So, if we are talking about external users of a company's accounting
information, then I would think of someone outside of the company. Who would be someone outside
of a company that is interested in any information that is generated in the accounting process?
Believe it or not, there really are several different categories of people that are very interested in this
type of information.

One of the most common categories of an external user is investors. These are the people
that use their personal money to buy, or invest, into a company. Since the goal of becoming a
shareholder in a business is to make money, investors are keenly interested in financial
information.

A second category of external users are creditors. There are a number of different types of
creditors that a business may have. A bank is an example of a creditor. A bank is a potential
financer for a business.
o

A supplier is another type of creditor. Oftentimes in business, suppliers sell needed

supplies to a business on a credit basis. The credit basis means that the supplies are
delivered without payment but with a guarantee that they will be paid for in a certain
time period.

A third type of external user of accounting information is the government. They want to know
how much money a company made in order to know how much taxes the company should
be paying. This is a vital part of our economy, and even though we don't always like it, paying
taxes is what keeps our world spinning.

External Uses of Accounting Information

Now that you know what an external user of accounting information is, what exactly is the information
that they use? Since an external user is someone with an outside interest in the company, they want
to know the bottom line when it comes to company finances.
The main items that interest this type of user are the financial statements. The accounting process
involves a number of procedures that are completed in certain steps. This process is called
the accounting cycle. One of the ending steps of the accounting cycle is to generate four financial
statements.
1. The first statement is the income statement. The income statement tells an external user
how much money a company made or lost in a given time period.
2. The second statement is the statement of retained earnings. This financial statement tells
external users how much of the net income shown on the income statement is reinvested in
the company.
3. The third financial statement that is generated is the balance sheet. The balance sheet tells
external users exactly what accounts a company has and the balance in each account.
4. The last financial statement is the statement of cash flows. The statement of cash flows
tells the external user what brought revenue in and where it was expensed out.

Internal Users of Accounting Information

Internal is the opposite of external. If that's so, then an internal user of accounting information would
be someone inside the company. They are the individuals who are directly involved in the company's
day-to-day operations. Who would that be, you wonder? Well, let's see.

Since a company is generally the bread and butter for its owner, company owners are
definitely internal users of accounting information. They are concerned not only with
profitability of the company but also in the longevity of the company.

Managers are also internal users of accounting information. They use accounting information
to see how well the company is operating under their guidance. They are also looking to see
if there are areas that they need to improve upon or areas that need to be cut in general.

Internal Uses of Accounting Information

Though internal and external users are two different groups of people, they do have one thing in
common. Both of these types of users rely on the same types of accounting information - the
financial statements. Owners use information on the financial statements to see how well the
company is performing. They need to know if the company is profitable, or if there are areas that
need to be addressed in order to make the company more profitable.
Managers use accounting information for a variety of reasons. First, the financial statements tell
them how much there is to allot for labor and for materials. This same bit of information also allows
them to forecast how much of a product can be produced. If the company is strictly a sales company,
then the financial statements let them see how much inventory can be purchased and how much
was sold in the last period. All of this information helps management and owners forecast future
supply and demand.

Introducing GAAP
Hi there! Let me introduce myself. My name is GAAP, and I am an accounting superhero! I bet you
wonder why, don't you? If you'll give me a few minutes of your undivided attention, I'll not only explain
to you why I'm an accounting superhero, but I'll also give you a brief history of myself. I'll even go so
far as to introduce you to some acquaintances of mine - SEC, FASB, and IASB. Are you ready?

What Is GAAP?
First of all, I should tell you that GAAP is actually my nickname. My full name is Generally Accepted
Accounting Principles. My name refers to a specific set of guidelines that have been established to

help publicly-traded companies create their financial statements. Publicly-traded companies are
companies that have made stock in their organization available for sale to the public. Unlike some
superheroes that are made up of plutonium and kryptonite, I am made up of 10 basic accounting
principles. They are:
1. Economic Entity Assumption
2. Monetary Unit Assumption
3. Time Period Assumption
4. Cost Principle
5. Full Disclosure Principle
6. Going Concern Principle
7. Matching Principle
8. Revenue Recognition Principle
9. Materiality
10. Conservatism
Let's take a minute to look at what each of my parts mean:
The economic entity assumption means that any activities of a business must be kept separate
from the activities of the business owner.
The monetary unit assumption means that only activities that can be expressed in dollar amounts
can be included in accounting records.
The time period assumption means that business activities can be reported in distinct time
intervals. These intervals may be in weeks, months, quarters, or in a fiscal year. Whatever the time
period is, it must be identified in the financial statement dates.
The cost principle refers to the historical cost of an item that is reported on the financial statements.
Historical cost is the amount of money that was paid for an item when purchased and is not changed
to account for inflation.
The full disclosure principle means that all information that is relative to the business be reported
either in the content of the financial statements or in the notes to the financial statements.
The going concern principle refers to the intent of a business to continue operations into the
foreseeable future and not to liquidate the business.

The matching principle refers to the manner in which a business reports income and expenses.
This principle requires that businesses use the accrual form of accounting and match business
income to business expenses in a given time period. For example, a sales expense should be
recorded in the same accounting period that sales income was made.
The revenue recognition principle addresses the manner in which revenue, or income, is
recognized. This standard requires that revenue be reported on the income statement in the period
in which it is earned.
The materiality principle refers to the measure of importance of a misstatement in accounting
records. For example, if the price of an asset is understated by $10.00, will that misstatement have
enough effect on the financial statements to matter? This is a gray area in accounting standards that
requires professional judgment to be used.
The last principle that makes me up is conservatism. Conservatism is the principle that calls for
potential expenses and liabilities to be recognized immediately if you are unsure whether they will
actually occur or not, but potential revenue not to be recognized until it is actually received.

History of GAAP
Now that you know what I am made of, let's talk about why I was created. Way back in 1929, a
significant event in American history occurred. It was called the Stock Market Crash of 1929, and it
affected not only those people who had placed their hard-earned money into corporate stocks and
bonds but also every single person in America. The 1929 stock market crash was a precursor to one
of the hardest economic times that has ever been known, the Great Depression.
During this time, many people lost faith in the stock market and in the American economy. The
government decided that there needed to be some way to rebuild that lost faith, and so, in the early
1930s, the Securities and Exchange Commission (SEC) was created.
The purpose of the SEC was to regulate financial practices among publicly-traded companies. In
1934, the SEC asked for assistance from the American Institute of Accountants, or the AIA, in
examining the formation of financial statements. Two years later, in a report on financial statement
formation, the concept of GAAP was mentioned for the very first time.
In the late 1930s, the AIA created a subcommittee to specifically create the GAAP principles. It was
called the Committee on Accounting Procedure, or CAP, and comprised 18 accountants and
three accounting professors. Shortly after CAP was formed, the first set of GAAP standards was
created. In 1973, the SEC decided to replace CAP with the Financial Accounting Standards
Board (FASB), which is still in place today.

What Influences GAAP?

There are a couple of organizations that have a direct influence on what I do. First of all, of course, is
the SEC. When the SEC was created, it was given the authority to regulate financial markets and

accounting standards boards. The SEC is directly responsible for creating another organization that
has a good bit of say in how much power I have.
This organization is the Financial Accounting Standards Board (FASB). The FASB is the board that
actually sets the standards that I represent. The FASB is made up of seven members, all of whom
are private-sector accounting professionals. These members are elected to five-year terms as
members of the FASB. They can be re-elected to a second five-year term but can only serve a
maximum of 10 years on the board. Upon accepting a position as a member of the FASB, the person
must immediately disassociate himself from the organization in which he worked.
A third important relation of mine is the International Accounting Standards Board (IASB). The
IASB is the body that sets the global standards for international accounting. There are 16 members
of this board that is based out of London. The members of this board are from diverse nationalities,
but each has the common interest of setting globally accepted accounting principles.
Now we get to the best part - Why am I an accounting superhero? The answer is simple. I am the
standards by which financial statements are prepared. Without me, a company could choose what
information it wanted to include on its financial statements. My mission is to ensure that information
on financial statements is relevant, reliable, comparable, and consistent.
Relevant information in accounting is information that has an impact on the financial status of a
company. Reliable information is information that can be verified as accurate if need be and is not
not just an educated guess. Comparable and consistent go hand-in-hand. These terms mean that
information on the financial statements is reported in the same manner for every publicly-traded
company. It is important for financial information to meet all those criteria so that potential investors
and creditors can make sound decisions on whether they do or don't want to enter into a business
relationship with a company.