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 offinancial accounting--to create useful financial information in the form of generalpurpose financial statements. In other words, 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.
The accounting cycle is a set of steps that are repeated in the same order every period. The
culmination of these steps is the preparation of financial statements. Some companies
prepare financial statements on a quarterly basis whereas other companies prepare them
annually. This means that quarterly companies complete one entire accounting cycle every
three months while annual companies only complete one accounting cycle per year.

Accounting Cycle Steps

This cycle starts with a business event. Bookkeepers analyze the transaction and record it
in the general journal with a journal entry. The debits and credits from the journal are then
posted to the general ledger where an unadjusted trial balance can be prepared.
After accountants and management analyze the balances on the unadjusted trial balance,
they can then make end of period adjustments like depreciation expense and expense
accruals. These adjusted journal entries are posted to the trial balance turning it into an
adjusted trial balance.
Now that all the end of the year adjustments are made and the adjusted trial balance
matches the subsidiary accounts, financial statements can be prepared. After financial
statements are published and released to the public, the company can close its books for
the period. Closing entries are made and posted to the post closing trial balance.
At the start of the next accounting period, occasionally reversing journal entries are made to
cancel out the accrual entries made in the previous period. After the reversing entries are
posted, the accounting cycle starts all over again with the occurrence of a new business
transaction.

Here is a simplified summary of the steps in a traditional accounting cycle. Some textbooks
list more steps than this, but I like to simplify them and combine as many steps as possible.
-- Identify business events, analyze these transactions, and record them as journal entries
-- Post journal entries to applicable T-accounts or ledger accounts
-- Prepare an unadjusted trial balance from the general ledger
-- Analyze the trial balance and make end of period adjusting entries
-- Post adjusting journal entries and prepare the adjusted trial balance
-- Use the adjusted trial balance to prepare financial statements
-- Close all temporary income statement accounts with closing entries
-- Prepare the post closing trial balance for the next accounting period
-- 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.

As you can see, the cycle keeps revolving every period. Note that some steps are repeated
more than once during a period. Obviously, business transactions occur and numerous
journal entries are recording during one period. Only one set of financial statements is
prepared however.
Throughout this section, we'll be looking at the business events and transactions that
happen to Paul's Guitar Shop, Inc. over the course of its first year in business. Let's take a
look at how Paul starts his accounting cycle below.

Journal Entries

T-Accounts
Unadjusted Trial Balance
Adjusting Entries
Adjusted Trial Balance
Financial Statements
Accounting Worksheet
Closing Entries
Income Summary Account
Post Closing Trial Balance
Reversing Entries

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. For example, when the company spends cash to
purchase a new vehicle, the cash account is decreased or credited and the vehicle account
is increased or debited.

Identify Transactions
There are generally three steps to making a journal entry. First, the business transaction
has to be identified. Obviously, if you don't know a transaction occurred, you can't record
one. Using our vehicle example above, you must identify what transaction took place. In this
case, the company purchased a vehicle. This means a new asset must be added to the
accounting equation.

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.

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. Here is an example of how the vehicle purchase would be
recorded.
Since there are so many different types of business transactions, accountants usually
categorize them and record them in separate journal to help keep track of business events.
For instance, cash was used to purchase this vehicle, so this transaction would most likely
be recorded in the cash disbursements journal. There are numerous other journals like the
sales journal, purchases journal, and accounts receivable journal.

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 Taccounts or ledger accounts in the next step of the accounting cycle.
Here is an additional list of the most common business transactions and the journal entry
examples to go with them.

Sale Entry
Depreciation Expense Entry
Accumulated Depreciation Entry
Accrued Expense Entry

Post Journal Entries to TAccounts or Ledger Accounts

Once journal entries are made in thegeneral journal or subsidiary journals, they must be
posted and transferred to the T-accounts or ledger accounts. This is the second step in the
accounting cycle.
The purpose of journalizing is to record the change in the accounting equationcaused by a
business event. Ledger accounts categorize these changes ordebits and credits into
specific accounts, so management can have useful information for budgeting and
performance purposes.
Since management uses these ledger accounts, journal entries are posted to the ledger
accounts regularly. Most companies have computerized accounting systems that update
ledger accounts as soon as the journal entries are input into the accounting software.
Manual accounting systems are usually posted weekly or monthly. Just like journalizing,
posting entries is done throughout each accounting period.
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.
Since most accounts will be affected by multiple transactions, there are usually several
numbers in both the debit and credit columns. Account balances are always calculated at
the bottom of each T-account. Notice that these are account balancesnot column
balances. The total difference between the debit and credit columns will be displayed on the
bottom of the corresponding side. In other words, an account with a credit balance will have
a total on the bottom of the right side of the account.
As a refresher of the accounting equation, all asset accounts have debit balances
and liabilityand equity accounts have credit balances. All contra accounts have opposite
balances.

Since so many transactions are posted at once, it can be difficult post them all. In order to
keep track of transactions, I like to number each journal entry as its debit and credit is
added to the T-accounts. This way you can trace each balance back to the journal entry in
the general journal if you have any questions later in the accounting cycle.
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.
Now these ledgers can be used to create an unadjusted trial balance in the next step of
theaccounting cycle.

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.
This is the third step in the accounting cycle. After the all the journal entries are posted to
the ledger accounts, the unadjusted trial balance can be prepared.
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.
Both the debit and credit columns are calculated at the bottom of a trial balance. As with
theaccounting equation, these debit and credit totals must always be equal. If they aren't
equal, the trial balance was prepared incorrectly or the journal entries weren't transferred to
the ledger accounts accurately.
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.

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.
Both the debit and credit columns are calculated at the bottom of a trial balance. As with the
accounting equation, these debit and credit totals must always be equal. If they aren't equal,
the trial balance was prepared incorrectly or the journal entries weren't transferred to the
ledger accounts accurately.
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

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.
You could 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.
You could also 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
thefinancial 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 conceptfinancial 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.
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.
For instance, banks often want basic financials to verify the a company can pay its debts,
while the SEC required audited financial statements from all public companies.
Financial statements are prepared by transferring the account balances on the adjusted trial
balance to a set of financial statement templates. We will discuss the financial statement
form in the next section of the course.
Example

Here is an example of Paul's Guitar Shop, Inc.'s financial statements based on his adjusted
trial balance in our previous example.
As you can see all four general-purpose financial statements are prepared and presented
here. Paul can use these statements internally to gauge the performance of his store for the
year or he can issue them to lenders or investors to help raise funds to expand the store.
Once the statements have been prepared, Paul can add the financial statements to
theaccounting worksheet and close his books for the year by recording closing entries in the
nextaccounting cycle step.

There is more technical information about how to prepare financial statements in the next
section of my accounting course.

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.
Each step lists its debits and credits with totals calculated at the bottom. Just like the trial
balances, the work sheet also has a heading that consists of the company name, title of the
report, and time period the report documents.

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 a 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.
I suggest using the accounting worksheet for all your year-end accounting problems. It
saves time and maintains accuracy in the process. Here is a downloadable excel version of
this accounting worksheet template, so you can use it with your accounting homework.

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 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 periodnot during the life of the company. We
don't want the 2015 revenue account to show 2014 revenue numbers.
Permanent accounts 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.
Example

In this example we will close Paul's Guitar Shop, Inc.'s temporary accounts using the
income summary account method from his financial statements in the previous example.
There are three general closing entries that must be made.

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.

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.

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
theincome 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.
At the end of each accounting period, all of the temporary accounts are closed. You might
have heard people call this "closing the books." Temporary accounts like income and
expenses accounts keep track of transactions for a specific period and get closed or reset at
the end of the period. This way each accounting period starts with a zero balance in all the
temporary accounts, so revenues and expenses are only recorded for current years.v
There are two ways to close temporary accounts. You can either close these accounts
directly to the retained earnings account or close them to the income summary account.
Closing temporary accounts to the income summary account does take an extra step, but it
also provides and an audit trail showing the revenues, expenses, and net income for the
year.
Once the temporary accounts are closed to the income summary account, the balances are
held there until final closing entries are made. This provides a useful check for errors. Once
all the temporary accounts are closed, the balance in the income summary account should
be equal to the net income of the company for the year.
Then the income summary account is zeroed out and transfers its balance to the retained
earnings (for corporations) or capital accounts (for partnerships). This transfers the income
or loss from an income statement account to a balance sheet account. This is the only time
that the income summary account is used. For the rest of the year, the income summary
account maintains a zero balance.
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 theclosing
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 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

An 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.
As with the unadjusted and adjusted trial balances, both the debit and credit columns are
calculated at the bottom of a trial balance. If these columns aren't equal, the trial balance
was prepared incorrectly or the closing entries weren't transferred to the ledger accounts
accurately.
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 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. For example, if
an accrued expense was recorded in the previous year, the bookkeeper or accountant can
reverse this entry and account for the expense in the new year when it is paid. The
reversing entry erases the prior year's accrual and the bookkeeper doesn't have to worry
about it.
If the bookkeeper doesn't reverse this accrual enter, he must remember the amount of
expense that was previously recorded in the prior year's adjusting entry and only account for
the new portion of the expenses incurred. He can't record the entire expense when it is paid
because some of it was already recorded. He would be double counting the expense.
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.