When a business engages in any economic activity, such as selling goods, purchasing supplies or paying salaries, these events must be recorded in the financial books. This is the first phase of the Accounting Cycle, and it lays the foundation for all subsequent steps.

The Source Documents

Every financial transaction in a business starts with a source document. Source documents are original records that contain the details pertinent to a financial transaction. Examples include sales receipts, purchase orders, invoices, and bank statements. They provide evidence that a transaction has physically taken place and offer the details necessary for recording the transaction, such as date, amount, and parties involved.

Journals and Journal Entries

The next step is recording the transaction in a journal, often referred to as the ‘book of original entry’. Journal entries consist of a minimum of two parts – a debit and a credit. All journal entries should conform to the rules of double-entry accounting, where for each transaction, the debits must equal the credits. Each journal entry is typically accompanied by a brief description of the transaction, as well as references to the source documents.

Ledger Accounts

After recording transactions in the journal, they must be posted to the ledger, which is the ‘book of final entry’. The ledger is a comprehensive collection of all the accounts of a business and their balances. Posting to the ledger involves transferring the debits and credits from the journal to their corresponding accounts in the ledger, which provides a more organized and detailed view of a company’s financial situation.

Double-entry System

In the double-entry system, every financial transaction affects at least two accounts in opposite ways, such that the accounting equation (Assets = Liabilities + Equity) remains balanced. This dual effect ensures the accuracy of the books and helps detect errors. For instance, if a company purchases inventory for cash, the inventory account will increase (debit), and the cash account will decrease (credit) by the same amount.

Preparing Trial Balance

Once all the transactions have been posted to the ledger accounts, the next step is to prepare the trial balance. The trial balance is a list of all ledger accounts and their balances at a specific point in time. Its purpose is to ensure that the total of all debits is equal to the total of all credits. If they match, it is presumed that the books are in balance. However, the trial balance cannot detect every kind of accounting error, so its balance is not conclusive proof of the absence of errors.

Adjunct Accounts and Adjusting Entries

Prepaid Expenses

Prepaid expenses are payments made for goods or services to be received in the future. They are considered assets until they are consumed. An adjusting entry is required to record the consumed portion as an expense and reduce the prepaid asset by the corresponding amount.

Accrued Revenues

Accrued revenues are earnings that have been recognized but not yet realized. For example, if services were provided but not billed by the end of the accounting period, the revenue for these services would be recorded through an adjusting entry that debits an accounts receivable and credits a revenue account.

Depreciation

Fixed assets, such as equipment and machinery, gradually lose value over time due to wear and tear, a process known as depreciation. It is accounted for by allocating the cost of the asset over its useful life. An adjusting entry debits the depreciation expense and credits the accumulated depreciation account.

Allowance for Doubtful Accounts

This account is used to estimate the portion of accounts receivable that may not be collectible. An adjusting entry is made to debit bad debt expense and credit the allowance for doubtful accounts, thus conveying a more accurate picture of likely cash inflows from receivables.

Creating Financial Statements

Balance Sheet

A balance sheet is a snapshot of a company’s financial condition at a single point in time and includes assets, liabilities, and shareholders’ equity. It provides stakeholders with a clear understanding of what the company owns and owes.

Income Statement

Also known as the profit and loss statement, the income statement shows the company’s revenues and expenses over a given period. It is used to calculate the net income of the business by subtracting expenses from earnings.

Cash Flow Statement

The cash flow statement covers the inflows and outflows of cash during an accounting period. It classifies cash flow into three activities: operating, investing, and financing, providing insight into a company’s liquidity and financial health.

Statement of Equity

The statement of equity shows changes in the ownership interest of a company’s shareholders over time. It includes contributions, distributions, and the earnings or losses of the period.

Closing the Books

Closing Entries

At the end of an accounting period, closing entries are used to clear out balances in temporary accounts — such as revenues, expenses, and dividends — and transfer their balances to permanent equity accounts such as retained earnings.

Post-Closing Trial Balance

After closing entries are made, a post-closing trial balance is prepared to ensure that the accounts are correctly balanced and ready for the next accounting period. This final step confirms that all temporary accounts have been closed and that the ledger is prepared for the next cycle.

The Accounting Cycle is critical as it ensures all financial transactions are accurately recorded, summarized, and presented in a clear and useful manner. Accounting basics form the foundation upon which the Accounting Cycle operates, ensuring standardization, legality, and analytical usefulness of the financial statements produced.