Basic Accounting: The Accounting Cycle Explained

Basic Accounting: The Accounting Cycle Explained

How the Accounting Cycle Works

What is the accounting cycle?

The accounting cycle is the holistic process of recording and processing all financial transactions of a company, from when the transaction occurs, to its representation on the financial statements. The cycle repeats itself every fiscal year as long as a company remains in business.

accounting cycle definition

If you spend $100 cash, put -$100 (credit/Negative) next to the cash account. The next step would be to balance that transaction with the opposite sign so that your balance sheet adds to zero. The way of doing these placements are simply a matter of understanding where the money came from and where it goes in the specific account types (like Liability and net assets account). So if $100 Cash came in and you Debited/Positive next to the Cash Account, then the next step is to determine where the -$100 is classified.

The general ledger serves as the eyes and ears of bookkeepers and accountants and shows all financial transactions within a business. Essentially, it is a huge compilation of all transactions recorded on a specific document or on accounting software, which is the predominant method nowadays. For example, if you want to see the changes in cash levels over the course of the business and all their relevant transactions, you would look at the general ledger, which shows all the debits and credits of cash. Figures under “Debits” and “Credits” have been posted to the T-account from the journal (see Exhibit 3, below, for sample journal transactions). Because Cash on Hand is an Asset account, it carries a so-called Debit balance.

What is accounting cycle with example?

The accounting cycle is the process of accepting, recording, sorting, and crediting payments made and received within a business during a particular accounting period.

Because these two are being used at the same time, it is important to understand where each goes in the ledger. Keep in mind that most business accounting software keeps the chart of accounts flowing the background and you usually look at the main ledger. Debits increase the balance of dividends, expenses, assets and losses. Credits increase the balance of gains, income, revenues, liabilities, and shareholder equity. An organization begins its accounting cycle with the recording of transactions using journal entries.

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Hence the income statement for December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance sheet dated December 31 should report the cost of five months of the insurance coverage that has not yet been used up.

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accounting cycle definition

The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events. After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal the total credits in the financial records. These are the result of corrections made and the results from the passage of time. For example, an adjusting entry may accrue interest revenue that has been earned based on the passage of time.

What is the Accounting Cycle?

If you got it as a loan then the -$100 would be recorded next to the Loan Account. If you received the $100 because you sold something then the $-100 would be recorded next to the Retained Earnings Account. If everything is viewed in terms of the balance sheet, at a very high level, then picking the accounts to make your balance sheet add to zero is the picture. The complete accounting equation based on modern approach is very easy to remember if you focus on Assets, Expenses, Costs, Dividends (highlighted in chart). Conversely, a decrease to any of those accounts is a credit or right side entry.

  • Keep in mind that most business accounting software keeps the chart of accounts flowing the background and you usually look at the main ledger.
  • Debits increase the balance of dividends, expenses, assets and losses.
  • Because these two are being used at the same time, it is important to understand where each goes in the ledger.

Step Six: Adjusted Trial Balance

At the end of any financial period (say at the end of the quarter or the year), the net debit or credit amount is referred to as the accounts balance. If the sum of the debit side is greater than the sum of the credit side, then the account has a “debit balance”.

Finally, a company prepares the post-closing trial balance to ensure debits and credits match. After all the transactions have been posted to the general ledger in the appropriate accounts, Cynthia will prepare an unadjusted trial balance. Cynthia needs to ensure that the debits and credits in the general ledger are balanced. For every debit entry, there should be a credit entry that keeps the books in balance. Based on the transactions recorded as part of the accounting cycle, financial statements such as cash flow reports, profit and loss statements, and balance sheets can be prepared.

Step Three: Post to General Ledger

Once all the business accounts have been balanced, they are closed out for that period and new ones created for the next accounting period. Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company’s accounting records, but the amount is for more than the current accounting period. To illustrate let’s assume that on December 1, 2019 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2019 through May 31, 2020. The $2,400 transaction was recorded in the accounting records on December 1, but the amount represents six months of coverage and expense. By December 31, one month of the insurance coverage and cost have been used up or expired.

accounting cycle definition

Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an adjusting entry will be needed at December 31, 2019 to get the income statement and balance sheet to report this accurately. A journal is also named the book of original entry, from when transactions were written in a journal prior to manually posting them to the accounts in the general ledger or subsidiary ledger. Manual systems usually had a variety of journals such as a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and a general journal. Depending on the business’s accounting information system, specialized journals may be used in conjunction with the general journal for record-keeping. In such case, use of the general journal may be limited to non-routine and adjusting entries.

On the other hand, increases in revenue, liability or equity accounts are credits or right side entries, and decreases are left side entries or debits. Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the financial statements. An entity closes temporary accounts, revenues, and expenses, at the end of the period using closing entries.

If the sum of the debit entries in a trial balance doesn’t equal the sum of the credits, that means there’s been an error in either the recording or posting of journal entries. The simplest most effective way to understand Debits and Credits is by actually recording them as positive and negative numbers directly on the balance sheet. If you receive $100 cash, put $100 (debit/Positive) next to the Cash account.

For accounts with a debit balance, debit entries increase the balance and credit entries decrease it. It is where double entry bookkeeping entries are recorded by debiting one or more accounts and crediting another one or more accounts with the same total amount. DetailDebitCreditCash$11,670-Accounts receivable-0–Prepaid insurance2,420-Supplies3,620-Furniture16,020-Accounts payable-220Unearned consulting revenue-3,000Notes payable-6,000Mr.

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When you add Assets, Liabilities and Equity together (using positive numbers to represent Debits and negative numbers to represent Credits) the sum should be Zero. Debits are money going out of the account; they increase the balance of dividends, expenses, assets and losses.

If the sum of the credit side is greater, then the account has a “credit balance”. Accounts with a net Debit balance are generally shown as Assets, while accounts with a net Credit balance are generally shown as Liabilities. The equity section and retained earnings account, basically reference your profit or loss. Therefore, that account can be positive or negative (depending on if you made money).

Basic Accounting: The Accounting Cycle Explained

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