FABM 1

Week 3: The Accounting Cycle

Have you ever wondered how does accounting works in the business? Is it simply recording in the journals and
posting in the ledgers? What does it take for a financial statement to be completed?
That is what we are going to dwell in this week’s lesson. As we move deeper in the realm of accounting, let us talk
about how can we apply the different accounting principles and concepts in analyzing and preparing financial
statements through the process – the accounting cycle.

THE ACCOUNTING CYCLE

Companies follow a standard schedule for recognizing financial transactions and the impact of those transactions.
The sequence of activities beginning with the occurrence of a transaction is known as the accounting cycle. The
accounting cycle involves several steps, which include identifying each financial transaction, recording the
financial transactions, analyzing and adjusting financial accounts, creating financial statements and setting up
each financial account to start the new period.
The accounting cycle for service companies and merchandising companies experiences some similarities and
differences.

What are the steps in the accounting cycle?

1. Identifying or Transaction Analysis
2. Journalizing
3. Posting to the Ledger
4. Preparing the Trial Balance
5. Making Adjusting Journal Entries
6. Preparing of Worksheet
7. Preparing of Financial Statements
8. Making Closing Entries
9. Preparing of Post-Closing Trial Balance
10. Making Reversing Entries

THE ACCOUNTING CYCLE

Step Process Activity

Identifying involves the process of determining quantifiable
transactions or events based on available supporting
documents. Supporting documents serve as evidence of the
existence of transactions to assure reliability and verifiability
of accounting records. The most common source
Identification of Events to be documents, among others, are invoices, official receipts,
1 delivery receipts, receiving reports, and check vouchers.
Recorded

Aim: To gather information about transactions or events

generally through the source documents.

2 Transactions are Recorded in Journalizing involves the mechanical and routine process of
 writing business transactions in the journal. A business
entity may use general journal or special journal to record
the various business transactions for the first time.
the Journal
Aim: To record economic impact of transactions on the firm
in a journal, which is a form that facilitates transfer to the
accounts.
Posting refers to the transfer of information from the journal
to the ledger. Posting involves the process of properly
classifying business transactions according to their nature
Journal Entries are Posted to and type.
3
the Ledger
Aim: To transfer the information from the journal to the
ledger for classification.
Trial balance is a listing of accounts with open balances. It
verifies the equality of debits and credits in the ledger. The
accounts in the trial balance should be arranged in the
following order: assets should be listed first, followed by the
4 Preparation of a Trial Balance liability accounts, capital accounts, income, and expenses
accounts.

Aim: To provide a listing to verify the equality of debits and

credits in the ledger.
Adjusting entries are intended to reflect the accruals,
expiration of deferrals, estimation and other events that will
update the account to its present balance. This type of
journal entry is usually made at the end of accounting
Making Adjusting Journal
5 period.
Entries
Aim: To record the accruals, expiration of deferrals,
estimations and other events.

The worksheet is a tool used by accountants to facilitate the

preparation of adjusting entries and the financial statements.
When the operation is simple and only few accounts are
6 Preparing of Worksheet involved, worksheet preparation can be omitted.

Aim: To aid in the preparation of financial statements.

Financial statements are the final product of accounting. The

operating performance and financial condition of the
business entity are communicated to various interested
Preparation of the Financial
7 users through the financial statements.
Statements
Aim: To provide useful information to decision-makers.

8 Making Closing Entries Nominal accounts, otherwise known as temporary accounts,

are closed at the end of the accounting period. Nominal
accounts are only used for a particular period, and they are
closed at the end of such period. The closing of nominal
accounts is done through the preparation of closing entries.
 Aim: To close temporary accounts and transfer profit to
owner’s equity.
Post-closing trial balance is a statement of financial position
in a trial balance form. Post-closing trial balance is made to
verify the equality of debits and credits after closing the
Preparing of Post-Closing Trial nominal accounts.
9
Balance
Aim: To check the equality of debits and credits after the
closing entries.

Some adjusting entries are reversed on the first day of the

next accounting period to facilitate and simplify the recording
process of the following period.
10 Making Reversing Entries
Aim: To simplify the recording of certain regular transactions
in the next accounting period.

This cycle is repeated each accounting period. The first three steps in the accounting cycle are accomplished
during the period. The fourth to ninth steps generally occur at the end of the period. The last step is optional and
occurs at the beginning of the next period.

In the previous lessons and discussions, we’re already done with the first three steps. As we journey accounting,
we will further discuss and deal with the other steps of accounting cycle.

What should you keep in mind in identifying transactions?

The analysis of transactions should follow these four basic steps:
1. Identify the transaction from source documents.
2. Indicate the accounts – either assets, liabilities, equity, income or expenses – affected by the transaction.
3. Ascertain whether each account is increased or decreased by the transaction.
4. Using the rules of debit and credit, determine whether to debit or credit the account to record its increase
or decrease.

What are the common examples of source documents?

📌THE SOURCE DOCUMENTS

Transactions and events are the starting points in the accounting cycle. By relying on source documents,
transactions and events can be analyzed as to how they will affect performance and financial position. Source
documents identify and describe transactions and events entering the accounting process. These original written
evidences contain information about the nature and the amounts of the transactions. These are the bases for the
journal entries; some of the more common source documents are:

»PURCHASE ORDER
A purchase order is an official business document issued by the buyer to the seller of goods. It indicates the
types of goods to be purchased, quantity or number, agreed price, shipping terms and conditions, delivery
schedule, and payment date.
Making a purchase order is the first step in the whole process of the ordering system. It constitutes a legal offer
to buy the product or services. Acceptance of the purchase order by a seller is usually in the form of contract.
The purchase order must be duly approved by authorized personnel.
»INVOICE
An invoice is a commercial document issued by the seller to the buyer. This contains the description of the
product, quantity, prices, payment term, due date of payment, and discount terms and conditions.
An invoice indicates that an exchange has taken place. There is a value received and value parted with. An
invoice can either be a sales invoice or a purchase invoice.
An invoice is usually issued whenever the sale of goods or services is made on credit. Upon the receipt of
goods or services as supported by the invoice, there arises the obligation oof the buyer to pay and the right of
the seller to collect.

»OFFICIAL RECEIPT
An official receipt is a commercial document that indicates payment or receipt of cash. Impliedly, the goods or
services have already been delivered or rendered.
The existence of an official receipt signifies that a particular transaction has taken place – the payment
transaction. The seller of goods or services received the cash, while the buyer of goods or services paid the
cash.

»DELIVERY RECEIPT
A document that serves as evidence that the goods or services have been received. As with the other business
documents, there is no prescribed design or format for delivery receipt.
It is assumed that the person receiving the goods or services, before signing the document, has checked the
completeness and condition of the goods in accordance with the purchase order. A delivery receipt serves only
as a proof of the delivery made and the receipt of goods.
No exchange of values takes place; hence, the information contained in the delivery receipt is not recorded in
the books of accounts.

»RECEIVING REPORT
A document used within the business upon receipt of the goods shipped by courier or forwarder. This document
is prepared by the person receiving the goods. The basis of the receiving report is the delivery receipt. The
information contained in the receiving report is not recorded in the books of accounts.

»CHECK
A check is a document that orders the payment of money from the current account maintained in the bank. It
serves as evidence of payment made. There is exchange of values in this type of business document; hence,
the transaction supported by the check should be recorded.

There are three persons involved in the issuance and payment of a check. They are the following:
1. Drawer – A depositor who maintains a current account in a bank that makes the order of payment.
2. Drawee – Usually a bank, makes the payment according to the order of the drawer.
3. Payee – The person or business entity receiving the payment on account of goods sold or services
rendered.

In line with the preparation of the trial balance, what is the most efficient approach
in locating an error?
📌LOCATING ERRORS
An inequality in the total of the debits and credits would automatically signal the presence of an error. These
errors include:

 Error in posting a transaction to the ledger.

a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit or vice versa.
c. A debit or credit posting was omitted.

 Error in determining the account balances.

a. A balance was incorrectly computed.
b. A balance was entered in the wrong balance column.

 Error in preparing the trial balance.

a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial balance.
c. A debit balance was recorded on the trial balance as a credit or vice versa, or a balance was
omitted entirely.

The following procedures when done in sequence may save considerable time and effort in locating errors:

1. Prove the addition of the trial balance columns by adding these columns in the opposite direction.
2. If the error does not lie in addition, determine the exact amount by which the trial balance is out of balance.
The amount of discrepancy is often a clue to the source of the error.
3. Compare the accounts and amounts in the trial balance with that in the ledger. Be certain that no account is
omitted.
4. Recompute the balance of each ledger account.
5. Trace all postings from the journal to the ledger accounts. As this is done, place a check mark in the journal
and in the ledger after each figure is verified. When the operation is completed, look through the journal and
the ledger for unchecked amounts. In tracing postings, be alert not only for errors in amount but also for
debits entered as credits, or vice versa.

Note that even when a trial balance is in balance, the accounting records may still contain errors. A balanced trial
balance simply proves that, as recorded, debits equal credits. The following errors are not detected by a trial
balance:

1. Failure to record or post a transaction.

2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.
4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.

📌REVIEW QUESTIONS:
1. What are the four basic steps that should be followed to attain a structured analysis of transactions?
2. The accounting cycle involves ten steps to accomplish the accounting process. Enumerate.
3. Cite some errors that will cause the debits and credits of the trial balance not to balance.

G E NE RAL I Z AT I O N
The accounting cycle refers to a series of sequential steps or procedures performed to accomplish the accounting
process. The steps in the cycle follow: identification of events to be recorded; transactions are recorded in the
journal; journal entries are posted to the ledger; preparation of a trial balance; adjusting journal entries are
journalized and posted; preparation of the worksheet including adjusting entries; preparation of the financial
statements; closing journal entries are journalized and posted; preparation of a post-closing trial balance; and,
reversing journal entries are journalized and posted. This cycle is repeated each accounting period.
“Capital isn’t this pile of money sitting somewhere; it’s an accounting
construct.” --Bethany McLean