Explain Accounting Cycle In Detail With Examples

 Explanation Of Accounting Cycle In Detail With Examples

The accounting cycle can be defined as an accounting activity of identifying, recording, and processing financial data from the beginning and resulting in financial statements at the end of the period (Wood & Sangster, 2005). Therefore, the sequence is made up of steps that have to be followed from the beginning to the end of an accounting period. Accountants of businesses – including the most popular Amazon, Facebook, Microsoft, Google, and Apple – have to account for, document, and report useful financial information of their business to the public. This provision allows those who have an interest in the business to view this important information because it shows how the business performed financially. When preparing financial statements like the income statement, statement of Retained Earnings, balance sheet, and cash flow statement, accountants must go through each step of the accounting cycle across the year to ensure accuracy (Betz, 2019). In addition, most businesses use software that processes massive accounting information.

Officially, an accounting cycle has eight accepted steps, especially when the double-entry system of bookkeeping is being used to record transactions (Hinojosa, 2021), but other businesses may decide to add additional steps to the eight.

The eight phases of the accounting cycle:

Step 1. Identifying and analyzing transactions from source documents

Step 2. recording transactions to journals

Step 3. posting to ledger

Step 4. prepare trial balance before adjustments

Step 5. Adjust entries for accuracy of worksheets

Step 6. Prepare Adjusted Trial balance

Step 7. Prepare Financial statement

Step 8 Closing Entries

Step 1. Identifying and Analyzing Transactions

The first step in the accounting cycle involves getting information from a source and identifying its purpose as a financial transaction. A source document will have details of a business transaction. sales receipts and purchase orders are examples of source documents. A business transaction can be viewed as a starting point for creating financial statements of a business because these transactions affect the financial information being reported on financial statements. Investments, borrowings, and selling goods and services are business transactions.

For instance, An accountant hired by Alan Gunna (which is a made-up business) looks through  source documents where she identified and analyzed the following business transactions for the month ending June 2021:

June 1st Started business with $50,000 cash.

June 3rd Paid for rent with $6,000 cash.

June 10th Purchased goods with cash for $7,500

June 17th Purchased machines on an account worth $15,000

June 28th Received $12,500 service fees cash.

Step 2. Recording Transactions To Journals

Betz (2019) showed how the transactions - identified in step 1 - are posted to the journals. Journals are sometimes called books of original entry. Ideally, Journals should be organized chronologically, starting with the first transactions of a certain period. All the transactions have to be recorded in their respective journals, using the accounting equation - which states that the business’s total assets should be equal to its liabilities and equity at a particular period. The journal entry should have at least two opposing transactions which are balanced (or equal).

Looking at the previous example of the Alan Gunna business,  the accountant will enter the identified transactions into journals as follow:

The Journal Entries

The Journal

2021 1st June Cash Alan. G Capital

Dr $ 50,000

Cr $ 50,000

The Journal

2021 3rd June Rent Expense Cash

Dr $ 6,000

Cr $ 6,000

The Journal

2021 10th June Stock Cash

Dr $ 7,500

Cr $ 7,500

The Journal

2021 17th June Machine Account payable

Dr $ 15,000

Cr $ 15,000

The Journal

2021 28th June Cash Service Revenue

Dr $ 12,500

Cr $ 12,500

Step 3 Posting To Ledger

Once the accountant records the transactions into a journal, they can now post them into the general ledger. This ledger is used by a business to track financial activities. Betz (2019) called a general ledger a summary of a business’s accounts. Since a Ledger account is a collection of all journal entries, it shows all the debits and credits of each business transaction. Wood & Sangster (2005) showed how accounts can be visually represented in a form of a T-account. This type of account has the debit side on the left and the credit side on the right: both sides are usually made equal by balancing the totals.

Example:

Dr Cash Cr

June 1^st 50,000 June 3^rd 6,000

28^th 12,500 10^th 7,500

balance c/d 49,000

62,500 62,500

balance b/d 49,000

Capital

balance b/d 50,000 June 1^st 50,000

50,000 50,000

balance b/d 50,000

Rent Expense

June 3^rd 6,000 balance c/d 6,000

6,000 6,000

balance b/d 6,000

Stock

June 10^th 7,500 balance c/d 7,500

7,500 7,500

balance b/d 7,500

Machine

June 17^th 15,000 balance c/d 15,000

15,000 15,000

balance b/d 15,000

Accounts payable

balance c/d 15,000 June 17^th 15,000

15,000 15,000

balance b/d 15,000

Service Revenue

balance c/d 12,500 June 28^th 12,500

12,500 12,500

balance b/d 12,500

Step 4 Prepare Trial Balance Before Adjustments

The unadjusted trial balance is prepared to find errors that might have occurred when entering financial information during the previous steps. AccountingTools (2021) states that the trial balance can be viewed as a list of all ledger accounts from the previous step and the balances on the debit side are expected to equal those of the credit side. When not equal, they are adjusted in the next step of the accounting cycle. During this step, the accountant takes the information in the general ledger to a trial balance that shows all total balances of debits in one column and credit entries in another column, at the same time. These total balances are obtained by adding all the debit balances and all the credit balances.

Step 5. Adjusting Entries For Accuracy Of Worksheets

At this step of the accounting cycle, the errors made from previous steps are edited and an ‘extended trial balance’, or worksheet is prepared: the debit and credit balances of the trial balance have to remain equal even after the adjustments. There are situations when the total balances of debits and credits are equal but errors exist, errors as posting to the wrong account (Hinojosa, 2021).

Example: If the accountant hired by Alan Gunna finds that the total debits and credits were $77,500 and $60,500 respectively. He has to go through all the journal entries carefully and identify the missing  $17,000 on the credit side before adjusting to the correct figure.

This step is important for accounting for accruals and deferrals. On one hand, the accruals are revenues or expenses that were incurred, but not recorded like payable wages, but on the other hand, deferrals are receipts of payments made in advance or treated as upcoming expenses such as prepaid insurance.

Step. 6 Prepare Adjusted Trial Balance

The adjusted trial balance is prepared after adjusting the entries and when the debit and credit totals are still equal.

For example, the accountant hired by Alan Gunna will prepare the following adjusted trial balance :

Alan Gunna

Trial balance

Period ending June 2021

Cash Rent expense Stock Machine Accounts payable Service Revenue Capital	Debit $ 49,000 6,000 7,500 15,000	Credit $ 15,000 12,500 50,000
Total	77,500	77,500

Step 7 Prepare Financial Statements

According to FreshBooks staff (2021), once the above trial balance is complete, it’s used to prepare financial statements like the income statement, Statement of Retained Earnings, the Balance Sheet, and the Cash Flow Statement. The net income found after the preparation of an Income Statement is used when preparing the statement of Retained Earnings, the ending balance in the Statement of Retained Earnings is used when preparing the balance sheet, and the statement of cash flow is the last one to be prepared because it uses information from the other financial statements.

The income statement reports the income of the business when expenses are deducted from revenues over a measured period. Therefore, it shows the financial performance of the business in a certain period. The balance sheet will show the financial position, in terms of assets compared with the liabilities and Equity, of a business at a point in time. In other words, the balance sheet presents a snapshot of the organization at the date for which it was prepared (Wood & Sangster, 2005). The cash flow statement gives light on the cash situation in a particular period, that is exactly where the cash was coming from, and where it went (inflows and outflows) and the cash flows are organized into categories of operating, investing, and financing activities. The preparation of these statements is necessary and they are reported for the whole public to see. The public may have different interests in a business and may want to know whether the business made profits, increased share values or assets, rewarded shareholders, and growth, etc. Therefore, critical information is required by the tax authority, society, customer, supplier, investors, partners, employees, and media. And, the financial statements prepared from the accounting cycle provide the required financial information.

Example

The preparation of Income Statement for Alan Gunna:

Alan Gunna

Income Statement

Period ending June 2021

Revenue:
Service Revenue	$ 12,500
Total Revenue		12,500
Expenses:
Rent Expenses	$ 6,000
Total Expenses		6,000
Net income		$6,500

Preparation of Statement of Retained Earnings for Alan Gunna:

Alan Gunna

Statement of retained earnings

Period ending June 2021

Balance 1/1/21	-
Net Income	$6,500
Less: Dividend	$6,500 -
Balance at end	$6500

Preparation of Balance Sheet for Alan Gunna

Alan Gunna

Balance sheet

Period ending June 2021

ASSETS	LIABILITIES
Cash $ 49,000 Machine 15,000 Stock 7,500	Accounts payable $ 15,000 EQUITY
	Capital $ 50,000 Retained income 6,500
Total Assets $ 71,500	Total Liabilities and Equity $ 71,500

Step 8 Closing Entries

Usually, the last step of the accounting cycle involves closing (or zeroing down) the Income Statement account at the end of the financial period and moving the balances to the balance sheet. Contrary, the balance sheet account is not closed because it shows the business’s financial position at a given period. The reason why the income statement account is zeroed down is to allow for the tracking of both revenues and expenses in the coming financial period.

Conclusion

The accounting cycle is an important process for any business that wishes to report the financial statements to those interested, including people and other institutions. The steps in the accounting cycle may be titled differently by accountants or software might be used to come up with reports, but no matter the title or software used, the same accounting principles are considered, especially when reporting transactions that happened during a certain period. Therefore, Gilbertson et al. (2013) show how all businesses (including well-known ones like Amazon and Facebook) have to disclose their financial performances to the public for their fiscal period.

References

• Wood F., Sangster A. (2005) Business Accounting 1 (10th ed.). Pearson Education Limited.

• Betz, J. (2019. August 16) What Is the Accounting Cycle? (+8 Easy Steps). learn.g2. https://learn.g2.com/accounting-cycle

• Hinojosa, A. (2012. July 2) What Is the Accounting Cycle? (With Steps and Examples). indeed. https://www.indeed.com/career-advice/career-development/accounting-cycle

• AccountingTools Team (2021. April 12) Adjusted trial balance example and explanation. AccountingTools.https://www.accountingtools.com/articles/what-is-an-adjusted-trial-balance.html

• lumen learning Team. (2021) Chronological, Step-by-Step, and Spatial Organization. lumen learning.https://courses.lumenlearning.com/wm-publicspeaking/chapter/chronological-step-by-step-and-spatial-organization/

• Gilbertson B. C., Lehman W. M., Harmon-Gentene D. (2013) Century 21 Accounting: General Journal, Introductory Course (10th ed.). Cengage Learning.

• Freshbooks Team. (2021) How to Prepare an Income Statement? A Simple 10 Step Business Guide. Freshbooks. https://www.freshbooks.com/hub/accounting/prepare-an-income-statement

1. Describe the steps in recording and posting the effects of a business transaction and provide some examples of source documents used in these steps.

solution

When recording accounting information, look through the source documents and identify all the business transactions. These transactions are then analyzed and measured for their effects on the business’ accounts. The transactions identified are then entered into their respective journals, and to ensure the accuracy of all the records, those journal entries are transferred to the general ledger.  The general ledger is separated into accounts, called T-accounts, showing what has been debited or credited.

2. Which steps in the accounting cycle are performed throughout the accounting cycle?

solution

The accounting cycle is a continuous eight-step process performed periodically and used by businesses to identify records, and process financial information. This information leads to financial statements that are disclosed to the public. Therefore, since the accounting cycle is continuous, the following steps are performed throughout the cycle: Identifying and analyzing transactions, recording them to journals, posting them to the ledger, preparing an adjusted trial balance, adjusting the entries, and preparing an adjusted trial balance.

3. Which of the steps in the accounting cycle are performed only at the end of the accounting period?

solution

The accounting cycle is a continuous process that never ends. That is, as long as the organization is still in business, the accounting cycle plays its parts, ensuring that accurate information is processed and reported to the public. Nevertheless, the step performed only at the end of the cycle is close entries of the temporary accounts (mostly) of the income statement.

4. What is the purpose of the "dividends" account and under what circumstances would this account be increased?

solution

The “dividends” account is for rewarding the stockholders (or owners) of the business with cash, during profitable times. Stockholders are rewarded for owning shares – or part of the stock. The management has a choice of retaining the earnings, instead of paying them out as dividends. Therefore, since retained earnings account increases with credits, the dividends account must increase with debits.

6. Describe the nature and purposes of the general journal, ledger, and chart of accounts.

solution

The general journal has the original entries of the business transactions. Therefore, It’s where the transactions are recorded first. The records of a transaction here can be traced easily when needed. 

The ledger is where the journal entries are posted and classified clearly to see which parts of a transaction are debits or credits. This information will be needed to prepare the trial balance, which in turn shows all the total debits and credits.

The chart of accounts (COA) is a financial organizational tool that provides a complete listing of every account in the general ledger and it clearly breaks them down into subcategories. This makes it easier to locate specific accounts because each chart of accounts typically contains a name, brief description, and an identification code.

7. What are the purposes of an unadjusted trial balance? Describe the types of accounts that would appear on this type of trial balance.

solution

The unadjusted trial balance is prepared to find errors that might have occurred when entering financial information during the previous steps. the trial balance can be viewed as a list of all ledger accounts and the balances on the debit side are expected to equal those on the credit side.

8. If you found that the total of the debits column of the trial balance for a company is $200,000, while the total of the credits column is $180,000, what are some possible causes of this difference?

solution

When the trial balance totals are not the same, we might consider that there were some mistakes when entering data into the journals and ledgers. For example, the might have been unbalanced entries, some entries might not have been made at all,  information may be entered more than once,  and some entries might have been entered into wrong accounts.

Part 2

Invested $20,000 cash in the golf course business.

Purchased Hampstead Golf Land for $15,000 cash. The price includes land $12,000, shed $2,000, and equipment $1,000.