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:

What Is the Accounting Cycle? The Important Step in Accounting Cycle

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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:

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:

 

Business ABC
Journal of Adjusting Entries
For the month of January 2016

S. No

Date

Account Description

Debit

Credit

1

31-Jan-16

 Rent Expense

25,000

 

 

 

              Prepaid Rent

 

25,000

 

 

 

 

 

 

 

(Adjustment of one month rent in prepaid rent account)

 

 

2

31-Jan-16

 Depreciation expense

11,667

 

 

 

              Accumulated Depreciation

 

11,667

 

 

 

 

 

 

 

(Purchase of plant and machinery through financing from bank)

 

 

3

31-Jan-16

 Provisions A/c

10,000

 

 

 

              Provision against doubtful debts

 

10,000

 

 

 

 

 

 

 

(Payment of factory rent for two months)

 

 

4

31-Jan-16

 Cost of Goods Sold

300,000

 

 

 

              Raw material inventory

 

300,000

 

 

 

 

 

 

 

(Consumption of raw material inventory)

 

 

The adjusted trial balance would be as follows:

Business ABC
Adjusted 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

 

Accumulated Depreciation

Provision

 

11,667

Raw Material Inventory*

Asset

0

 

Accounts Receivable

Asset

100,000

 

Provision against doubtful receivables

Provision

 

10,000

Bank Account

Asset

1,190,000

 

Prepaid rent **

Asset

25,000

 

Sales

Income

 

750,000

Staff salaries

Expense

60,000

 

Electricity expense

Expense

55,000

 

Rent expense

Expense

25,000

 

Depreciation expense

Expense

11,667

 

Provisions

Expense

10,000

 

Cost of goods sold

Expense

300,000

 

   

2,476,667

2,476,667

*   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:

 

BUSINESS ABC

 

Profit & Loss Account

 

For the month ended January 31, 2016

 
 

$

   

Sales

750,000

Less: Cost of Goods Sold

300,000

Gross Profit

450,000

   

Less: Expenses

 

Staff salaries

60,000

Electricity expense

55,000

Rent expense

25,000

Depreciation expense

11,667

Provisions (for doubtful receivables)

10,000

 

161,667

   

Profit for the period

288,333

   

 

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

 

BUSINESS ABC
Balance Sheet (Format#2)
As at January 31, 2016

 

$

ASSETS

   

Plant & Machinery

700,000

 

Less: Accumulated Depreciation

(11,667)

688,333

     

Accounts Receivable

100,000

 

Less: Provision against doubtful receivables

(10,000)

90,000

     

Prepaid Rent

 

25,000

Cash at bank

 

1,190,000

   

1,993,333

Less: LIABILITIES

   

Long Term Loan

 

700,000

Accounts Payable

 

150,000

Accrued expenses

 

55,000

   

905,000

     

NET ASSETS

 

1,088,333

     

Share Capital

 

800,000

Retained earnings

 

288,333

   

1,088,333

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