What is the Accounting Cycle?

The accounting cycle is a step by step process of collecting, summarizing, recording, and presenting financial information. The Accounting process can be divided into 6 sub-processes as follows:

We’ll discuss all these processes in detail in this section for better understanding.

 Process -1: Recording transactions through Journal Entries

Before explaining Journal Entries, we need to understand the concept of the Chart of Accounts.

Chart of Accounts

Chart of Accounts is a list of all general ledger accounts being used by a Company. The purpose of maintaining a chart of accounts is to keep things organized by specifying an account for each type of transaction and to avoid misclassifications while posting general entries.

In order to keep things simple, a predefined numbering scheme is used to differentiate between different categories of accounts. The most commonly used numbering scheme use prefix 1 for assets, 2 for liabilities, 3 for equity, 4 for incomes, and 5 for expenses. An example of a simple chart of accounts is as follows.

Account Number	Account Description
1010001	Cash in hand
1010002	Cash at bank
1020001	Accounts Receivable
1030001	Fixed Assets
2010001	Accounts Payable
2020001	Short term running finance
3010001	Share Capital
3020001	Accumulated profit/Loss
4010001	Sale Revenue
4020001	Other income
5010001	Cost of goods sold
5020001	Salaries and wages
5020002	Utilities
5030001	Marketing Expenses

Above is a simplified example. In practice, the chart of accounts would contain a lot of other accounts as well which will keep on adding as per defined numbering criteria.

Journal Entry

A journal entry is the set of information needed to document a business transaction. The minimum information required for a complete journal entry is as follows:

• Date of transaction
• Ledger accounts related to the transaction
• Account to be debited or credited
• Value of the transaction

Depending on the accounting system used, many additional facts can also be stored other than the basic details.

Journal entries under accrual and cash basis of accounting

As explained earlier, there are two bases for the recording of accounting transactions i.e. cash basis and accrual basis of accounting.

Under the cash basis, transactions are recorded as and when related cash flow occurs i.e. revenues are recorded when the amount is received while expenses are recorded when related amounts are actually paid.

While under an accrual basis, transactions are recorded at the time of occurrence in line with accrual concept. i.e. revenue is recorded at the time of sale of goods or rendering of services whether or not related amounts have been received. Similarly, expenses are recorded at the time when those are incurred irrespective of when they would be paid.

The example below explains the difference of accounting entries under the two accounting systems:

Comprehensive Example:

Consider the following transactions. We’ll use these as a continued example for explaining

1.	Jan1st:	Capital injected by shareholder–$800,000
2.	Jan5th:	Plant and machinery obtained through financing from bank – $700,000
3.	Jan10th:	Paid factory rent for two months – $ 50,000
4.	Jan10th:	Raw material purchased – $300,000 (50% on cash, 50% on credit)
5.	Jan20th:	Sales made on credit basis – $ 450,000
6.	Jan25th:	Sales made on cash basis – $ 300,000
7.	Jan29th:	Amount recovered from credit customers – $ 350,000
8.	Jan30th:	Paid employees’ salaries – $60,000
9.	Jan30th:	Estimate of electricity bill for January – $ 55,000 (not paid yet)

Now let’s post these transactions in the Journal.

Business ABC Journal For the month of January 2016
S.No	Date	Account Description	Debit	Credit
1	1-Jan-16	Bank Account	800,000
		Share Capital		800,000
		(Capital injected by shareholder)
2	5-Jan-16	Plant & Machinery	700,000
		Long Term Loan		700,000
		(Purchase of plant and machinery through financing from bank)
3	10-Jan-16	Prepaid Rent	50,000
		Bank Account		50,000
		(Payment of factory rent for two months)
4	10-Jan-16	Raw Material Inventory	300,000
		Accounts Payable		150,000
		(Purchase of raw material) (50% on cash basis, 50% on credit basis)
5	20-Jan-16	Accounts Receivable	450,000
		Sales		450,000
		(Sale of goods on credit terms)
6	25-Jan-16	Bank Account	300,000
		Sales		300,000
		(Sale of goods on cash basis)
7	29-Jan-16	Bank Account	350,000
		Accounts Receivable		350,000
		(Recovery of amount from credit customers)
8	29-Jan-16	Salaries expense	60,000
		Bank Account		60,000
		(Payment of employees’ salaries)
9	30-Jan-16	Electricity expense	55,000
		Accrued Expenses		55,000
		(Booking of accrual for electricity expense)

Compound Journal Entry

When two transactions of the same nature happen on the same date we can record a compound journal entry for both transactions as in case of entry number 4 in the table above. However, while posting compound entries it should be taken care of that the total of Debit and Credit columns is equal.

Process-2: Posting Journal Entries to General Ledger

General Ledger is the consolidated picture of all transactions related to a particular account head whether it is an asset, liability, equity, income or expense account.. A general ledger contains the following information:

• Date of transaction
• Folio number (reference to the accounting entry contained in Journal)
• Description of transaction
• Amount of transaction and it impact (Debit or Credit)
• Account balance after each transaction

A sample general ledger is shown below for reference:

Why general ledgers are prepared:

All accounting entries are chronologically recorded in the Journal and it is very difficult to extract and summarize in one place all the transactions pertaining to a specific head of account. To solve this problem, general ledgers are prepared for all accounts and all accounting entries are first entered in the Journal and are then posted to respective ledger account. As a result, we get a consolidated picture of transactions pertaining to a specific account head.

Continued Example:

General ledger of Bank Account based on our continued example would be as follows:

Business ABC Bank Account Ledger For the month of January 2016
Date	Folio NO.	Description	Debit ($)	Credit ($)	Balance ($)
		Opening Balance			Debit 0
1-Jan-16	1	Capital injection by shareholder	800,000		Debit 800,000
10-Jan-16	3	Payment of factory rent		50,000	Debit 750,000
20-Jan-16	4	Purchase of raw material inventory		150,000	Debit 600,000
25-Jan-16	6	Sale of goods on cash basis	300,000		Debit 900,000
29-Jan-16	7	Recovery from credit customers	350,000		Debit 1,250,000
29-Jan-16	8	Payment of employees’ salaries	60,000		Debit 1,190,000
		Closing Balance			Debit 1,190,000

T accounts

T – Account is an alternate format of presenting the general ledger in which ledger is maintained in a T shaped format with debit and credit transactions separated on either side of the T. It is popular among accounting staff due to the ease of understandability.

Following steps must be considered while preparing ledger in T-Accounts format:

• Opening balance of ledger account is mentioned on left side in case of debit nature accounts (i.e. Assets and Expenses) or on the right side in case of Credit nature accounts (i.e. Equity, Liabilities)
• All Debit transactions are recorded on the left side of T partition
• All Credit transactions are recorded on the right side of T partition
• Closing balance is calculated by adding the net of debit and credit transactions to opening balance and is written on the opposite side to the one where opening balance was written. Alternatively, closing balance can also be calculated as the balancing figure on the respective side.

Below is the Bank Account Ledger in T Format based on data of example discussed earlier:

Business ABC Bank Account Ledger (T-Account) For the month of January 2016
Date	Folio NO.	Description	Amount	Date	Folio NO.	Description	Amount
		Opening Balance	0
Jan 1	1	Capital injection by shareholder	800,000	Jan 10	3	Payment of factory rent	50,000
Jan 25	6	Sale of goods on cash basis	300,000	Jan 20	4	Purchase of raw material	150,000
Jan 29	7	Recovery from credit customers	350,000	Jan 29	8	Payment of employees’ salaries	60,000
						Closing Balance	1,190,000
			1,450,000				1,450,000

Process 3: Preparing the Trial Balance

Trial Balance is a list of all general ledger accounts and their closing balances at a particular date. In order to prepare financial statements, we need closing balances of all accounts, an information which can be obtained from individual ledger accounts but it is always good to prepare trial balance which summarizes all account balances at one place.

We have discussed earlier that in double entry book keeping debit and credit amount in every accounting entry is equal. As a result the total of debit and credit columns of trial balance should be equal. If it is not equal then either there was an error in recording of accounting entries.

The trial balance prepared from ledger balances is also termed as “Unadjusted Trial Balance”. Management may need to incorporate certain adjusting entries in it before using it for preparation of financial statements. An example of trial balance based on our continuing example from above would be as follows:

Business ABC Trial Balance As at January 31, 2016
Account Description	Type	Debit	Credit
Share Capital	Equity		800,000
Long Term Loan	Liability		700,000
Accounts Payable	Liability		150,000
Accrued expenses	Liability		55,000
Plant & Machinery	Asset	700,000
Raw Material Inventory	Asset	300,000
Accounts Receivable	Asset	3100,000
Bank Account	Asset	1,190,000
Prepaid rent	Asset	50,000
Sales	Income		750,000
Staff salaries	Expense	60,000
Electricity expense	Expense	55,000
		2,455,000	2,455,000

Note: The ‘type’ column is not part of trial balance rather it has been inserted here just for understanding purpose.

Process 4: Year/Period-end adjustments

Companies most often need to make some closing adjustments at year end or whenever they want to prepare financial statements. These may include following items:

Accruals	As discussed earlier that under accrual basis of accounting, a business needs to recognize earned income whether or not received and to recognize expenses incurred whether or not paid. If business has not already recognized all accrued income or expenses as required under accrual concept then it must incorporate adjusting entries to that effect. Example: Every business when following accrual basis of accounting, needs to record actual or estimated expense of utilities (electricity, gas, water) at monthend even if payment is to be made during next month.              Utilities expense (Debit)            xxxx Utilities payable (Credit)    xxxx Similarly, from income point of view,businesses needs to assess at every period end, whether they have made any sales or provided any services for which it has not billed yet and if that is the case they need to record that revenue in same period. Accrued receivable (Debit)     xxxx Sale revenue          xxxx
Adjustments of prepaid expenses/ income	Businesses do sometime make prepayments for expenses which might need to be adjusted at period end for the period expired. On the other hand a business may have received advance money against services which might need adjustment at period end.
Non–cash items	Other non-cash items may also require adjustments. Prime examples of such entries are depreciation and provision for doubtful debts.

Incorporating above adjustments would give us the Adjusted Trial Balance which then can be used for preparing financial statements.

 

ContinuedExample:

We have already accrued electricity expense so let’s move on to other adjustments such as prepayments, depreciation and provisions. Assume following adjustments:

• Adjustment of prepaid rent for one month i.e. $ 25,000
• Adjustment for depreciation expense (assuming useful life of 5 years i.e. depreciation rate of 20%) (Depreciation for one month would be = Rs 700,000 x 20% x 1/12 = 11,667)
• Recognize a provision for doubtful receivables at the rate of 10% of outstanding receivables (i.e. $ 100,000) Provision for doubtful receivables would be = $ 100,000 x 10% = 10,000)
• Incorporate entry for recording consumption of raw material during the period. Consider that there is no closing inventory of raw material or finished goods and all items produced have been sold during the period.

Accounting entries for above adjustments would be as follows:

 

The adjusted trial balance would be as follows:

*   Raw material inventory = 300,000 – 300,000 = NIL
**   Prepaid Rent = 50,000 – 25,000 = 25,000

 

Process 5: Preparing financial statements

 

The next step in accounting cycle after incorporating the adjusting entries in trial balance is the preparation of financial statements. A complete set of financial statements includes:

1. Balance Sheet
2. Profit & Loss Account
3. Cash flow statement
4. Statement of changes in Equity
5. Notes to the accounts

 

We will prepare the first 2 items i.e. Balance Sheet and Profit & Loss Account using the data from above.
Profit & Loss Account:

Profit & Loss Account summarizes the operational performance of a business over a period as it incorporates all “Income” and “Expense” nature accounts from adjusted trial balance. An example of profit & loss account based on above data is as follows:

 

 

Balance Sheet:

Balance Sheet shows the financial position of a business at a particular date as it incorporates all “Equity”, Liability” and “Asset” nature accounts from adjusted trial balance.

Balance sheet can be presented in two formats based on the accounting equation:

Format#1       Assets = Equity + Liabilities

Under this format, Equity and Liabilities are shown on one side while Assets are shown on the other side in a way that both sides are equal.

Format#2       Equity = Assets -Liabilities

Under this format, Equity is shown as net of assets and liabilities.

Examples of both formats are given below.

BUSINESS ABC Balance Sheet (Format#1) As at January 31, 2016
		$				$
EQUITY				ASSETS
Share Capital		800,000		Plant & Machinery	700,000
Retained earnings		288,333		Less:Accumulated  dep.	(11,667)	688,333
		1,088,333
				AccountsReceivable	100,000
LIABILITIES				Less:Provision against doubtfulreceivables
Long Term Loan		700,000			(10,000)	90,000
Accounts Payable		150,000
Accrued expenses		55,000		Prepaid Rent		25,000
		905,000		Cash at bank		1,190,000
		1,993,333				1,993,333