Accounting Cycle

 Accounting cycle is the financial process starting with recording business transactions and
leading up to the preparation of financial statements.
 This process demonstrates the purpose of financial accounting--to create useful financial
information in the form of general-purpose financial statements.
 The sole purpose of recording transactions and keeping track of expenses and revenues is
turn this data into meaning financial information by presenting it in the form of a balance
sheet, income statement, statement of owner's equity, and statement of cash flows.
Accounting Cycle Steps (Here is a simplified summary of the steps in a traditional
accounting cycle)
1. Identify business events, analyze these transactions, and record them as journal entries
2. Post journal entries to applicable T-accounts or ledger accounts
3. Prepare an unadjusted trial balance from the general ledger
4. Analyze the trial balance and make end of period adjusting entries
5. Post adjusting journal entries and prepare the adjusted trial balance
6. Use the adjusted trial balance to prepare financial statements
7. Close all temporary income statement accounts with closing entries
8. Prepare the post-closing trial balance for the next accounting period
9. Prepare reversing entries to cancel temporary adjusting entries if applicable
Flow Chart
After this cycle is complete, it starts over at the beginning. Here is an accounting cycle flow
chart.

1. Journal Entries
 Journal entries are the first step in the accounting cycle and are used to record all
business transactions and events in the accounting system. As business events occur
throughout the accounting period, journal entries are recorded in the general journal to
show how the event changed in the accounting equation.
There are generally three steps to making a journal entry
1. Identify Transactions
 The business transaction has to be identified. Obviously, if you don't know
a transaction occurred, you can't record one.

2. Analyze Transactions
 After an event is identified to have an economic impact on the accounting
equation, the business event must be analyzed to see how the transaction
changed the accounting equation.
 When the company purchased the vehicle, it spent cash and received a
vehicle. Both of these accounts are asset accounts, so the overall
accounting equation didn't change. Total assets increased and decreased
by the same amount, but an economic transaction still took place because
the cash was essentially transferred into a vehicle.

3. Journalizing Transactions
 After the business event is identified and analyzed, it can be recorded.
 Journal entries use debits and credits to record the changes of the
accounting equation in the general journal.
  Traditional journal entry format dictates that debited accounts are listed
before credited accounts. Each journal entry is also accompanied by the
transaction date, title, and description of the event.
Example
We are following Paul around for the first year as he starts his guitar store called
Paul's Guitar Shop, Inc. Here are the events that take place.

Journal Entry 1 -- Paul forms the corporation by purchasing 10,000 shares of $1 par
stock.

Journal Entry 2 -- Paul finds a nice retail storefront in the local mall and signs a lease
for $500 a month.

Journal Entry 3 -- PGS takes out a bank loan to renovate the new store location for
$100,000 and agrees to pay $1,000 a month. He spends all of the money on
improving and updating the store's fixtures and looks.

Journal Entry 4 -- PGS purchases $50,000 worth of inventory to sell to customers on

account with its vendors. He agrees to pay $1,000 a month.

Journal Entry 5 -- PGS's first rent payment is due.

Journal Entry 6 -- PGS has a grand opening and makes it first sale. It sells a guitar for
$500 that cost $100.

Journal Entry 7 -- PGS sells another guitar to a customer on account for $300. The
cost of this guitar was $100.
Journal Entry 8 -- PGS pays electric bill for $200.

Journal Entry 9 -- PGS purchases supplies to use around the store.

Journal Entry 10 -- Paul is getting so busy that he decides to hire an employee for
$500 a week. Pay makes his first payroll payment.

Journal Entry 11 -- PGS's first vendor inventory payment is due of $1,000.

Journal Entry 12 -- Paul starts giving guitar lessons and receives $2,000 in lesson
income.

Journal Entry 13 -- PGS's first bank loan payment is due.

 Journal Entry 14 -- PGS has more cash sales of $25,000 with cost of goods of
$10,000.

Journal Entry 15 -- In lieu of paying himself, Paul decides to declare a $1,000

dividend for the year.

Now that these transactions are recorded in their journals, they must be posted to
the T-accounts or ledger accounts in the next step of the accounting cycle.

2. Post Journal Entries to T-Accounts or Ledger Accounts

 Once journal entries are made in the general journal or subsidiary journals, they must
be posted and transferred to the T-accounts or ledger accounts.
 The purpose of journalizing is to record the change in the accounting equation caused
by a business event. Ledger accounts categorize these changes or debits and credits
into specific accounts, so management can have useful information for budgeting and
performance purposes.

T-Account

 Ledger accounts use the T-account format to display the balances in each account.
Each journal entry is transferred from the general journal to the corresponding T-
account. The debits are always transferred to the left side and the credits are
always transferred to the right side of T-accounts.

 As a refresher of the accounting equation, all asset accounts have debit balances
and liability and equity accounts have credit balances. All contra accounts have
opposite balances.

Example
Let's post the journal entries that Paul's Guitar Shop, Inc. made during the first year in
business to the ledger accounts.
 As you can see, all of the journal entries are posted to their respective T-accounts and
the account balances are calculated on the bottom of each ledger account.

3. Unadjusted Trial Balance

 An unadjusted trial balance is a listing of all the business accounts that are going to
appear on the financial statements before year-end adjusting journal entries are made.
That is why this trial balance is called unadjusted.
Format
  An unadjusted trial balance is displayed in three columns: a column for account
names, debits, and credits. Accounts with debit balances are listed in the left
column and accounts with credit balances are listed on the right.

 Accounts are usually listed in order of their account number. Most charts of
accounts are numbered in balance sheet order, so the unadjusted trial balance also
displays the account numbers in balance sheet order starting with the assets,
liabilities, and equity accounts and ending with income and expense accounts.

 As with all financial reports, trial balances are always prepared with a heading.
Typically, the heading consists of three lines containing the company name, name of
the trial balance, and date of the reporting period.

Preparation

Posting accounts to the unadjusted trial balance is quite simple. Basically, each one of the
account balances is transferred from the ledger accounts to the trial balance. All accounts
with debit balances are listed on the left column and all accounts with credit balances are
listed on the right column. That's all there is to it.

Example

After Paul's Guitar Shop, Inc. records its journal entries and posts them to ledger accounts,
it prepares this unadjusted trial balance.

 As you can see, all the accounts are listed with their account numbers with corresponding
balances. In accordance with double entry accounting, both of the debit and credit
columns are equal to each other.
  Managers and accountants can use this trial balance to easily assess accounts that must
be adjusted or changed before the financial statements are prepared.

 After the accounts are analyzed, the trial balance can be posted to the accounting
worksheet and adjusting journal entries can be prepared.

4. Adjusting Entries
 Adjusting entries, also called adjusting journal entries, are journal entries made at the
end of a period to correct accounts before the financial statements are prepared.
 Adjusting entries are most commonly used in accordance with the matching principle to
match revenue and expenses in the period in which they occur.

Adjusting Entry Types

 There are three different types of adjusting journal entries. Each one adjusts income
or expenses to match the current period. This concept is based on the time period
principle which states that accounting records and activities can be divided into
separate time periods. In other words, we are dividing income and expenses into
the amounts that were used in the current period and deferring the amounts that
are going to be used in future periods.

AJEs are used to record:

Prepaid expenses or unearned revenues – Prepaid expenses are goods or services

that have been paid for by a company but have not been consumed yet. Insurance is a
good example of a prepaid expense. Insurance is usually prepaid at least six months. This
means the company pays for the insurance but doesn't actually get the full benefit of the
insurance contract until the end of the six-month period. This transaction is recorded as a
prepayment until the expenses are incurred.

Accrued expenses and accrued revenues – Many times companies will incur expenses
but won't have to pay for them until the next month. Utility bills are a good example.
December's electric bill is always due in January. Since the expense was incurred in
December, it must be recorded in December regardless of whether it was paid or not. In
this sense, the expense is accrued or shown as a liability in December until it is paid.

Non-cash expenses – Adjusting journal entries are also used to record paper expenses
like depreciation, amortization, and depletion. These expenses are often recorded at the
end of period because they are usually calculated on a period basis. For example,
depreciation is usually calculated on an annual basis. Thus, it is recorded at the end of the
year. This also relates to the matching principle where the assets are used during the year
and written off after they are used.

Recording AJEs

Recording adjusting journal entries is quite simple. The process includes three main steps:

 Determine current account balance

 Determine what current balance should be
  Record adjusting entry

These adjustments are then made in journals and carried over to the account ledgers and
accounting worksheet in the next accounting cycle step.

Example

Following our year-end example of Paul's Guitar Shop, Inc., we can see that his unadjusted
trial balance needs to be adjusted for the following events.

-- Paul pays his $1,000 January rent in December.

-- Paul's December electric bill was $200 and is due January 15th.

-- Paul's leasehold improvement depreciation is $2,000 for the year.

-- On December 31, a customer prepays Paul for guitar lessons for the next 6 months.
 -- Paul's employee works half a pay period, so Paul accrues $500 of wages.

Now that all of Paul's AJEs are made in his accounting system, he can record them on the
accounting worksheet and prepare an adjusted trial balance.

5. Adjusted Trial Balance

 An adjusted trial balance is a listing of all company accounts that will appear on the
financial statements after year-end adjusting journal entries have been made.
 Preparing an adjusted trial balance is the fifth step in the accounting cycle and is the
last step before financial statements can be produced.

Format

 An adjusted trial balance is formatted exactly like an unadjusted trial balance. Three
columns are used to display the account names, debits, and credits with the debit
balances listed in the left column and the credit balances are listed on the right.

  Like the unadjusted trial balance, the adjusted trial balance accounts are usually listed
in order of their account number or in balance sheet order starting with the assets,
liabilities, and equity accounts and ending with income and expense
accounts.

Preparation

There are two main ways to prepare an adjusted trial balance. Both ways are useful
depending on the site of the company and chart of accounts being used.

1. Post accounts to the adjusted trial balance using the same method used in creating the
unadjusted trial balance. The account balances are taken from the T-accounts or ledger
accounts and listed on the trial balance. Essentially, you are just repeating this process
again except now the ledger accounts include the year-end adjusting entries.

2. Take the unadjusted trial balance and simply add the adjustments to the accounts that
have been changed. In many ways this is faster for smaller companies because very
few accounts will need to be altered.

Note that only active accounts that will appear on the financial statements must to be
listed on the trial balance. If an account has a zero balance, there is no need to list it on
the trial balance.
 Example

Using Paul's unadjusted trial balance and his adjusted journal entries, we can prepare the
adjusted trial balance.

Once all the accounts are posted, you have to check to see whether it is in balance.
Remember that all trial balances' debit and credits must equal.

Now that the trial balance is made, it can be posted to the accounting worksheet and the
financial statements can be prepared.

Financial Statement Preparation

 Preparing general-purpose financial statements; including the balance sheet, income

statement, statement of retained earnings, and statement of cash flows; is the most
important step in the accounting cycle because it represents the purpose of financial
accounting.

 In other words, the concept financial reporting and the process of the accounting cycle are
focused on providing external users with useful information in the form of financial
statements.
  These statements are the end product of the accounting system in any company.
Basically, preparing these statements is what financial accounting is all about.

Logical order for their preparation:

1. Income statement
2. Statement of retained earnings
3. Balance sheet
4. Cash flow statement

Income Statement

 The income statement reports revenues, expenses, and the resulting net
income. It is prepared by transferring the following ledger account balances,
taking into account any adjusting entries that have been or will be made:
 Revenue
 Expenses
 Capital gains or losses Statement of Retained Earnings

Statement of Retained Earnings

 The retained earnings statement shows the retained earnings at the beginning
and end of the accounting period. It is prepared using the following information:
 Beginning retained earnings, obtained from the previous statement of
retained earnings.
 Net income, obtained from the income statement
 Dividends paid during the accounting period Balance Sheet

Balance Sheet

 The balance sheet reports the assets, liabilities, and shareholder equity of the
company. It is constructed using the following information:
 Balances of all asset accounts such cash, accounts receivable, etc.
 Balances of all liability accounts such as accounts payable, notes, etc.
 Capital stock balance
 Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement

 The cash flow statement explains the reasons for changes in the cash balance,
showing sources and uses of cash in the operating, financing, and investing
activities of the firm. Because the cash flow statement is a cash-basis report, it
cannot be derived directly from the ledger account balances of an accrual
accounting system. Rather, it is derived by converting the accrual information to
a cash-basis using one of the following two methods:
1. Direct method
 Cash flow information is derived by directly subtracting cash
disbursements from cash receipts.
2. Indirect method
 Cash flow information is derived by adding or subtracting non-cash
items from net income. Income Statement
Preparation

 Preparing general-purpose financial statements can be simple or complex depending on

the size of the company. Some statements need footnote disclosures while other can be
presented without any. Details like this generally depend on the purpose of the financial
statements.
  Financial statements are prepared by transferring the account balances on the adjusted
trial balance to a set of financial statement templates.

Accounting Worksheet

 An accounting worksheet is a tool used to help bookkeepers and accountants complete the
accounting cycle and prepare year-end reports like unadjusted trial balances, adjusting
journal entries, adjusted trial balances, and financial statements.
Format

 The accounting worksheet is essentially a spreadsheet that tracks each step of the
accounting cycle.
 The spreadsheet typically has five sets of columns that start with the unadjusted trial
balance accounts and end with the financial statements.
 In other words, an accounting worksheet is basically a spreadsheet that shows all of the
major steps in the accounting cycle side by side.
Example
Here is what Paul's Guitar Shop's year-end would look like in accounting worksheet format for
the accounting cycle examples in this section.

 As you can see, the worksheet lists all the trial balances and adjustments side by side.
During the accounting cycle process, an accounting worksheet can be helpful to keep
track of the different steps and reduce errors.

 It can also be used for an analytical and summary tool to show how accounts were
originally posted to the ledger and what adjustments were made before they were
presented on the financial statements.
Closing Entries
  Closing entries, also called closing journal entries, are entries made at the end of an
accounting period to zero out all temporary accounts and transfer their balances to
permanent accounts.
 In other words, the temporary accounts are closed or reset at the end of the year. This is
commonly referred to as closing the books.

Temporary accounts

 These are income statement accounts that are used to track accounting activity during
an accounting period. For example, the revenues account records the amount of
revenues earned during an accounting period—not during the life of the company. We
don't want the 2015 revenue account to show 2014 revenue numbers.
Permanent accounts

 These are balance sheet accounts that track the activities that last longer than an
accounting period. For example, a vehicle account is a fixed asset account that is
recorded on the balance. The vehicle will provide benefits for the company in future
years, so it is considered a permanent account.

At the end of the year, all the temporary accounts must be closed or reset, so the beginning of
the following year will have a clean balance to start with. In other words, revenue, expense, and
withdrawal accounts always have a zero balance at the start of the year because they are always
closed at the end of the previous year. This concept is consistent with the matching principle.

Closing Entry Types

 Temporary accounts can either be closed directly to the retained earnings account or to
an intermediate account called the income summary account. The income summary
account is then closed to the retained earnings account. Both ways have their
advantages.

 Closing all temporary accounts to the income summary account leaves an audit trail for
accountants to follow. The total of the income summary account after the all temporary
accounts have been close should be equal to the net income for the period.

 Closing all temporary accounts to the retained earnings account is faster than using the
income summary account method because it saves a step. There is no need to close
temporary accounts to another temporary account (income summary account) in order
to then close that again.
Both closing entries are acceptable and both result in the same outcome. All temporary accounts
eventually get closed to retained earnings and are presented on the balance sheet.

There are three general closing entries that must be made.

1. Close all revenue and gain accounts

All of Paul's revenue or income accounts are debited and credited to the income summary
account. This resets the income accounts to zero and prepares them for the next year.

Remember that all revenue, sales, income, and gain accounts are closed in this entry. Paul's
business or has a few accounts to close.
 2. Close all expense and loss accounts
All expense accounts are then closed to the income summary account by crediting the expense
accounts and debiting income summary.

3. Close all dividend or withdrawal accounts

Since dividend and withdrawal accounts are not income statement accounts, they do not
typically use the income summary account. These accounts are closed directly to retained
earnings by recording a credit to the dividend account and a debit to retained earnings.
Now that all the temporary accounts are closed, the income summary account should have a
balance equal to the net income shown on Paul's income statement. Now Paul must close the
income summary account to retained earnings in the next step of the closing entries.

Income Summary Account

 The income summary account is a temporary account used to store income statement
account balances, revenue and expense accounts, during the closing entry step of the
accounting cycle.

 In other words, the income summary account is simply a placeholder for account balances
at the end of the accounting period while closing entries are being made.

Example
After Paul's Guitar Shop prepares its closing entries, the income summary account has a
balance equal to its net income for the year. This balance is then transferred to the
retained earnings account in a journal entry like this.

After this entry is made, all temporary accounts, including the income summary account,
should have a zero balance.
 Now that Paul's books are completely closed for the year, he can prepare the post-closing
trial balance and reopen his books with reversing entries in the next steps of
the accounting cycle.
Post-Closing Trial Balance

 The post-closing trial balance is a list of all accounts and their balances after the closing
entries have been journalized and posted to the ledger.
 In other words, the post-closing trial balance is a list of accounts or permanent accounts
that still have balances after the closing entries have been made.

 This accounts list is identical to the accounts presented on the balance sheet. This makes
sense because all of the income statement accounts have been closed and no longer have
a current balance.

 The purpose of preparing the post-closing trial balance is to verify that all temporary
accounts have been closed properly and the total debits and credits in the accounting
system equal after the closing entries have been made.

Format

 A post-closing trial balance is formatted the same as the other trial balances in the
accounting cycle displaying in three columns: a column for account names, debits, and
credits.
 Since only balance sheet accounts are listed on this trial balance, they are presented in
balance sheet order starting with assets, liabilities, and ending with equity.

Preparation

 Posting accounts to the post-closing trial balance follows the exact same procedures as
preparing the other trial balances. Each account balance is transferred from the ledger
accounts to the trial balance. All accounts with debit balances are listed on the left
column and all accounts with credit balances are listed on the right column.
 The process is the same as the previous trial balances. Now the ledger accounts just
have post-closing entry totals.

Example

After Paul's Guitar Shop posted its closing journal entries in the previous example, it
can prepare this post-closing trial balance.
  Notice that this trial balance looks almost exactly like the Paul's balance sheet except
in trial balance format. This is because only balance sheet accounts are have balances
after closing entries have been made.

 Now that the post-closing trial balance is prepared and checked for errors, Paul can
start recording any necessary reversing entries before the start of the next accounting
period.

Reversing Entries

 Reversing entries, or reversing journal entries, are journal entries made at the beginning of
an accounting period to reverse or cancel out adjusting journal entries made at the end of
the previous accounting period.

 This is the last step in the accounting cycle.

 Reversing entries are made because previous year accruals and prepayments will be paid
off or used during the New Year and no longer need to be recorded as liabilities and assets.
These entries are optional depending on whether or not there are adjusting journal entries
that need to be reversed.

 Reversing entries are usually made to simplify bookkeeping in the New Year.

Example
It might be helpful to look at the accounting for both situations to see how difficult bookkeeping
can be without recording the reversing entries. Let's look at let's go back to your accounting
cycle example of Paul's Guitar Shop.
In December, Paul accrued $250 of wages payable for the half of his employee's pay period that
was in December but wasn't paid until January. This end of the year adjusting journal entry
looked like this:

Accounting with the reversing entry:

Paul can reverse this wages accrual entry by debiting the wages payable account and crediting
the wages expense account. This effectively cancels out the previous entry.
But wait, didn't we zero out the wages expense account in last year's closing entries? Yes, we
did. This reversing entry actually puts a negative balance in the expense. You'll see why in a
second.
On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then record
the payment by debiting the wages expense account for $500 and crediting the cash account for
the same amount.
Since the expense account had a negative balance of $250 in it from our reversing entry, the
$500 payment entry will bring the balance up to positive $250-- in other words, the half of the
wages that were incurred in January.

See how easy that is? Once the reversing entry is made, you can simply record the payment
entry just like any other payment entry.
Accounting without the reversing entry:
If Paul does not reverse last year's accrual, he must keep track of the adjusting journal entry
when it comes time to make his payments. Since half of the wages were expensed in December,
Paul should only expense half of them in January.
On January 7th, Paul pays his employee $500 for the two week pay period. He would debit wages
expense for $250, debit wages payable for $250, and credit cash for $500.

The net effect of both journal entries have the same overall effect. Cash is decreased by $250.
Wages payable is zeroed out and wages expense is increased by $250. Making the reversing
entry at the beginning of the period just allows the accountant to forget about the adjusting
journal entries made in the prior year and go on accounting for the current year like normal.
As you can see from the T-Accounts above, both accounting method result in the same balances.
The left set of T-Accounts are the accounting entries made with the reversing entry and the right
T-Accounts are the entries made without the reversing entry.
Recording reversing entries is the final step in the accounting cycle. After these entries are
made, the accountant can start the cycle over again with recording journal entries. This cycle
repeats in the exact same format throughout the current year.