The Accounting Cycle
The accounting cycle is a series of steps performed during the accounting period (some throughout the period and some at the end) to analyze, record, classify, summarize, and report useful financial information for the purpose of preparing financial statements. In bookkeeping, the accounting period is the period for which the books are balanced and the financial statements are prepared. Generally, the accounting period consists of 12 months. However, the beginning of the accounting period differs according to the company. For example, one company may use the regular calendar year, January to December, as the accounting year, while another entity may follow April to March as the accounting period.
Eight Steps in the Accounting Cycle
There are eight steps in the accounting cycle and they are as follows:
- Analyze transactions by examining source documents.
- Journalize transactions in the journal.
- Post journal entries to the accounts in the ledger.
- Prepare a trial balance of the accounts and complete the worksheet (includes adjusting entries).
- Prepare financial statements.
- Journalize and post adjusting entries.
- Journalize and post closing entries.
- Prepare a post-closing trial balance.
Source Documents
To begin the accounting cycle, it is necessary to understand what constitutes a business transaction. Business transactions are measurable events that affect the financial condition of a business. Business transactions can be the exchange of goods for cash between the business and an external party, such as the sale of a book, or they can involve paying salaries to employees. These events have one fundamental thing in common: they have caused a measurable change in the amounts in the accounting equation, assets = liabilities + stockholders' equity. The evidence that a business event has occurred is a source document. Sales tickets, checks, and invoices are common source documents. Source documents are important because they are the ultimate proof that a business transaction has taken place.
After determining, via the source documents, that an event is a business transaction, it is then entered into the company books via a journal entry. After all the transactions for the period have been entered into the appropriate journals, the journals are posted to the general ledger . The trial balance proves that the books are in balance or that the debits equal the credits. From the trial balance, a company can prepare their financial statements. After the financials are prepared, the month end adjusting and closing entries are recorded (journalized) and posted to the appropriate accounts. After those entries are made, a post-closing trial balance is run. The post-closing trial balance verifies the debits equal the credits and that all beginning balances for permanent accounts are in place.
The General Ledger
The General Ledger contains all entries from both the General Journal and the Special Journals.
Highland Yoga
As we walk through the steps of the accounting cycle, consider the following example. After a number of years as a successful CPA at a national firm, you decide to quit the rat race and pursue your true love -- yoga. You decide that Atlanta's Virginia-Highland neighborhood would be the perfect place to open an Ashtanga Yoga studio. Even better, your friend Solomon, a certified instructor, has just moved to town and is willing to teach at the studio. You hurriedly prepare to open the studio, Highland Yoga, by July 1.
Pre-opening (before July 1)
Prior to opening the business, you make the following transactions:
1. You contribute $4,000 in cash to start the business.
2. You purchase $500 worth of mats and other equipment for use during classes.
3. You purchase an additional $400 worth of mats, equipment, and clothing for sale at the studio.
4. You purchase liability insurance at a total cost of $1,200. The policy covers July 1 through December31.
July
The following transactions take place during July.
1. You receive cash totaling $800 for classes.
2. Your instructor teaches classes for the month. You agree to pay $600 for the classes; $300 is paid on July 15, and $300 will be paid on August 3.
3. You pay rent for July of $1,000 on July 1.
4. You use utilities (electricity and water) totaling $200. This amount is payable on August 15.
August
The following transactions take place during August.
1. You receive $1,500 in cash for classes. Of this amount, $1,000 was for classes in August. The remainder is for 2-month passes allowing unlimited classes in August and September.
2. Your instructor again earns $600 teaching classes; $300 due on August 16 and $300 on September 1.
3. Utilities total $150, payable September 15.
4. You pay rent of $1,000 on August 1.
5. You sell inventory costing $150 for a revenue of $225.
6. You are worried about money, so your Uncle Rafael makes you an offer. He agrees to loan you $2,000 in cash. You will need to repay him sometime later, but he doesn't say when.
7. A client is extremely dissatisfied with their class, and demands their money back. Reluctantly, you agree. The class cost $15.
8. After borrowing money, you decide to withdraw some of your investment in the studio to pursue other opportunities. You decide to withdraw $1,000.