In today’s entry we’re going to look at the accounting cycle. This is a relatively simple concept, and shouldn’t take long to explain. Some of these concepts will be expanded upon in future entries, but I’ll try to provide concise enough explanations for today’s blog.
The accounting cycle consists of 10 steps, though some textbooks may have fewer or more.
The steps are:
- Identify the Transaction
- Analyze the Transaction
- Record in the Journal
- Post to the Ledger
- Create a Trial Balance
- Make Adjusting Entries
- Create the Adjusted Trial Balance
- Create the Financial Statements
- Make Closing Journal Entries
- Create the Post-Closing Trial Balance
Identify the Transaction: this is the recognition that a transaction has taken place, it usually begins with something we call a Source Document. Simply put a source document is what will identify a transaction has (or is) taking place. Examples of source documents which involve transactions include receipts, invoices (bills), purchase orders, etc.
Analyze the Transaction: Since we have identified a transaction as taking place, for example our boss gave us a receipt, now we have to examine the transaction (receipt) to see what accounts might be involved. For example if the receipt in question was for office supplies and she paid in cash we have all the information we need. The accounts in question are going to be Office Supply Expense, and Cash. Other pieces we have/need are the amount, and the date—all present on the receipt.
Record in the Journal: This is creating the entry from the information we determined above. For more info on this step see my entry on double entry bookkeeping.
Post to the Ledger: This step is deceptively simply. First off the ledger (or general ledger) is simply a record of an individual account. It contains a running total of the individual accounts balance. I’ll go into more detail on ledgers in a future entry, for now just stick with my explanation.
Create the Trial Balance: The trial balance is a report which shows the balance of every account. Since some accounts have Debit balances and others have Credit balances and we have learned that Debits = Credits, the trial balance serves to prove that we are indeed in balance. This step may seem trivial; however it is crucial that we are in balance before we move into the next steps.
Make Adjusting Entries: In this step we are going to make any necessary adjustments to the journal for end of the year/period/accounting cycle etc. These might be overwhelming right now, mostly because I haven’t yet introduced the concept of accrual (vs. cash) accounting. Although a common adjustment would be adding any additional (but unpaid) interest on a loan.
Create the Adjusted Trial Balance: Similar to the first trial balance however this time, we are again checking to ensure we are in balance. Further more from this trial balance we will use it to create the financial statements.
Create the Financial Statements: This process will require its own blog entry however; the basic financial statements are the Income Statement, Balance Sheet, Statement of Cash Flows, and the Statement of Retained Earnings. Together these statements reflect the financial condition and position of the firm.
Make Closing Entries: We the completion of the statements we have to close the temporary (income statement) accounts so that they are ready to record transactions in the next cycle.
Create the Post Closing Trial Balance: Yes, I know by now you don’t want to create another trial balance, but this again is needed to verify that the accounting system is in balance going into the new cycle.
Thanks for your reading, please comment, and tune in for the next blog entry!
