Accounting cycle Definition:

Accounting cycle is the collective process of recording and processing accounting transactions. It stars from occurrence of transaction and ends on after closing trial balance.

Accounting cycle steps:

 

Following are steps of accounting cycle.

  1. Trasaction:
  2. Journal entries
  3. Posting
  4. Unadjusted trial balance
  5. Adjusting entries
  6. Adjusted trial balance
  7. Preparation of finanacial statements
  8. Closing entries
  9. Post closing trial balance

Accounting cycle Flowchart:

accounting cycle flowchart, explanation with examples

 

Explanation of each step:

Analysing transaction and recording in books:

First step in accounting cycle is identify, analyse and record the transaction. Easy way to understand the transaction is identify the accounts involved and determine whether it is personal or business trasaction. In small business, many transactions are for personal purpose. Do not record those transaction in books but show them in capital account of owner. This is the duty of junior accountant generally.

Journalizing the transaction:

Next step is do journal entry of transaction. Journal entry can be done using accounting equation or golden rules of accounting. Remember that right entry leads to right accounting and helps to show right profit/loss for the business and true position of assets and liablities.

Posting to the ledger:

There are plenty of transactions in business. These transactions are segmented in ledgers ( Account). All the transactions related to same account is recorded in ledger. Ledger posting is easy process. In which, debit entry is posted on debit side of ledger and credit entry is posted on credit side of ledger. After posting, Balancing is done by finding difference of sum of debits and sum of credits. Read full article about preparation of T accounts- Here.

Preparation of unadjusted trial balance:

All the balances of ledgers are posted in unadjusted trial balance. Unadjusted trial balance is list of accounts and balances without adjustments. Learn how to prepare unadjusted trial balance from this post.

Adjusting entries:

There are many adjustments which may be pending to be recorded or considered in accounts. Those transactions are recorded using adjusting entries. Adjusting entries are ledger entries done to record adjustments in accounts.

Following adjustments are covered under adjustments:

  1. Prepayments and accruals
  2. Writing off depreciation
  3. Writing off bad debt
  4. Adjusting entry for obsolesce inventory.
  5. Recording ommitted transactions – Unrecorded bills or invoices

Preparation of adjusted trial balance:

Once all the adjustments are recorded through adjusting entries, adjusted trial balance is prepared considering adjustments.

Preparation of 10 column worksheet:

In large companies, accountant prepare 10 column worksheet to track all the remaining adjustments. In 10 column worksheet, there are 10 columns covering unadjusted trial balance, adjustments, income statements and balance sheet. Preparation of 10 column worksheet makes preparation of financial statements easy and error free. Remember that it is not compulsory to prepare 10 column worksheet in accounting.

Preparation of financial statements:

Financial statements include income statement ( Profit and loss account) and Balance sheet and  cash flow statements as part of financial statements.

Income statement:

Income statement which is also called profit and loss account ( P&L account) . Income statement is In income statements, all the incomes are recorded on credit side and all the expenses are recorded on debit side. Profit / Loss is calculated using the difference of sum of both side.

Balance sheet:

Balance sheet presents financial position of company for reporting date. Balance sheet covers three elements refers as Assets, Liabilities and capital.

Notes to Financial statements:

Financial statements also includes notes to financial statements.Common notes includes advice on significant accounting policies, notes about depreciating assets, notes about inventory valuation, notes about disclosure of subsequent events, notes about contingent liabilities, notes about dept, consolidation financial statements notes.

Closing entries:

Closing entries are required to close all the temporary accounts ( Income accounts, Expense accounts and withdrawals) and transfer their balances to permanent account ( Income statements). In this way, all the income and expense has nil balance at the end of accounting period and next year, the income accounts and expense accounts are started with zero. Closing of books needs time and effort when there are large number of ledgers and sub ledgers or there are many subsidiaries.

Post closing trial balance:
Post closing trial balance is prepared after closing entries are done. It contains all the balance sheet accounts.It helps to verify that sum of  the debit balances are equal to the sum of the credit balances.  It is last step in accounting cycle.

 

Accounting cycle Example:

We understand accounting cycle with following transactions of business.

  1. Mr. Zen has started business of selling furniture on 1/5/2015 with $2,00,000 capital.
  2. Mr. Zen has bought furniture ( Inventory) on cash $2,0000.
  3. Mr. Zen has purchased van for business use – $2000.
  4. Mr. Zen has received loan from bank $10,000.
  5. Mr. Zen has sold furniture for $30,000 on cash.
  6. Mr. Zen has sold furniture for $2,000 on 30 days credit to Mr. Smart.
  7. Mr. Zen has paid salary to Miss Lilly $500.
  8. Mr. Zen has purchase furniture on credit $1,000 from Mr.Happy .
  9. Mr. Zen has sold furniture on cash $1600.
  10. Mr. Zen has received money from Mr. Smart.
  11. Mr. Zen has paid advertising expense $200.
  12. Mr.Zen has withdraws $300 from business for personal use.
  13. Mr. Zen has paid $200 as taxes.
  14. Received purchase order $2000.

Accounting cycle steps for above example:

 

Analysing transactions and recording in books:

First step is identifying and analyzing relevant transaction. Some transactions are relevant to personal account of Mr.zen which we transfer to capital account. In transaction no. 14, there is order received. Order received is not monetary transaction so we ignore that transaction while making accounts.

Journal entry of transaction:

From above transaction, we make journal entries.

No. Entry Dr Cr
1 Bank a/c Dr 2,00,000
To Mr. Zen a/c 2,00,000
2 Purchase a/c Dr 20,000
To Bank 20,000
3 Van a/c Dr 2,000
To bank 2,000
4 Bank a/c Dr 10,000
To Loan a/c 10,000
5 Bank a/c Dr 30,000
To Sales a/c 30,000
6 Mr. Smart a/c Dr 2,000
To Sales a/c 2,000
7 Salary a/c Dr 500
To bank 500
8 Purchase a/c Dr 1,000
To Mr. Happy 1,000

 

For remaining transaction, do journal entry your own as exercise.

Preparation of Ledgers:

From journal entries, we prepare ledgers. If you are not familiar with process of preparation of T accounts, read my post here.  I have already prepared the ledgers which you can see below:

Bank a/c

Date Part. $ Date Part. $
To Mr.Zen 2,00,000 By salary 500
To Loan 10,000 By purchase 20,000
To sales 30,000 By advertising 200
To sales 1,600 By Drawing 300
To Mr. Smart 2,000 By Tax 200
By van 2,000
By Balance c/d 2,20,400
2,43,600 2,43,600

 

Zen a/c

Date Part. $ Date Part. $
To Bal c/d 2,00,000 By bank a/c 2,00,000
2,00,000 2,00,000

 

Purchase a/c

Date Part. $ Date Part. $
To Bank a/c 20,000 By balance c/d 21,000
To Mr. Happy 1,000
21,000 21,000

 

Van a/c

Date Part. $ Date Part. $
To bank 2,000 By balance c/d 2,000
2,000 2,000

 

Sales a/c

Date Part. $ Date Part. $
To bal. c/d 33,600 By Bank a/c 30,000
By Mr. Smart a/c 2,000
By bank a/c 1600
33,600 33,600

 

Mr.smart’s a/c

Date Part. $ Date Part. $
To Sales 2,000 By bank a/c 2,000
2,000 2,000

 

Salary a/c

Date Part. $ Date Part. $
To Bank 500 By bal c/d 500
500 500

 

Mr. Happy a/c

Date Part. $ Date Part. $
To bal. c/d 1,000 By Purchase 1,000
1,000 1,000

 

Advertising Exp

Date Part. $ Date Part. $
To Bank 200 By bal c/d 200
200 200

 

Drawing a/c

Date Part. $ Date Part. $
To bank 300 By bal c/d 300
300 300

 

Tax a/c

Date Part. $ Date Part. $
To Bank 200 By bal c/d 200
200 200

Preparation of Unadjusted Trial Balance:

From balances of ledgers above, we prepare unadjusted Trial balance.

Ledger Debit Credit
Bank 2,20,400
Zen 2,00,000
Tax 200
Drawing 300
Advertising 200
Mr.Happy 1,000
Salary 500
Loan from Bank 10,000
Sales 33,600
Purchase 21,000
Van 2,000
Total 2,44,600 2,44,600

Recording adjustments:

Following adjustments are needed to record:

  1. Salary $100 is pending at year end.
  2. Advance received from customer $200.
  3. Loan repaid $200 which is pending to record.
  4. Insurance paid in advance $400.

We make following adjusting entries:

No. Journal Entry Debit Credit
1 Salary a/c Dr 100
To salary Payable a/c 100
2 Bank a/c Dr 200
To Advance received 200
3 Loan from bank a/c Dr 200
To Bank 200
4 Insurance paid in advance Dr 400
To bank a/c 400

 

Preparation of adjusted Trial balance :

Adjusted trial balance has same format as of unadjusted trial balance. The difference is that it considered adjustment made at year end.

Ledger Debit Credit
Bank 2,20,000
Zen 2,00,000
Tax 200
Drawing 300
Advertising 200
Mr.Happy 1,000
Salary 600
Loan from Bank 9,800
Sales 33,600
Purchase 21,000
Van 2,000
Insurance paid in advance 400
Advance Received 200
Salary payable 100
Total 244700 2,44,700

Preparation of 10 column worksheet:

10 column worksheet consist of unadjusted trial balance balances, adjustment, adjusted trial balance’ figures, Income statements, balance sheet. We discuss preparation of 10 column worksheet in upcoming article. Remember that preparation of 10 column worksheet is not mandatory and worksheet is not part of financial statements.

Preparation of financial statements:

Financial statements consist income summary account or profit and loss account and balance sheet.

Income summary account

Expense $ Income $
Advertising 200 Sales 33600
Salary 600
Purchase 21000
Tax 200
Net Profit 11,600
33,600 33,600

 

Balance Sheet

Asset $ Liabilities $
Van 2000 Capital 2,11,300
Bank 2,20,000 Loan From bank 9,800
Insurance paid in advance 400 Mr.Happy 1,000
Advance received 200
Salary Payable 100
2,22,400 2,22,400

Closing entries:

Closing entries is process of transfer temporary accounts to permanent account. It is last step in accounting cycle.

Entry Dr Cr
Profit and loss account Dr 22,000
To Advertising a/c 200
To salary a/c 600
To Tax 200
To Purchase a/c 21000
Sales a/c Dr 33,600
To Profit and loss a/c 33,600
Profit and loss a/c Dr 11,600
To Zen a/c 11.600

 

Post closing trial balance:

Post closing trial balance is snapshot of balance sheet presented in trial balance format.

Ledger Debit Credit
Van 2,000
Bank 2,20,000
Insurance paid in advance 400
Loan from bank 9,800
Mr.Happy 1,000
Advance received 200
Salary payable 100
Mr.Zen 2,11,300
2,22,400 2,22,400

In this article, you learn complete accounting cycle from preparation of ledgers to closing entries. If you want to test your accounting knowledge, you can join my accounting video course. Join now and get 50% discount. Here is the discounted link.

Share This

Share this post with your friends!

Get FREE Small Business Accounting Course in Your Inbox

Get FREE Small Business Accounting Course in Your Inbox

Join our mailing list to start your Free Accounting Course. 

 

You have Successfully Subscribed!