MODULE OF INSTRUCTION

Module 2

The Accounting Cycle

This topic might already be familiar with you for this was discussed in
your past courses. So let’s just have a review on the financial
statement preparation by going over the accounting cycle.

In this lesson you should be able to review of the Accounting Cycle

and Basic Financial Statements.

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2.1 The Accounting Cycle

This part is a brief review of your learning from your ABM subjects.

The accounting cycle is a series of steps starting with recording

business transactions and leading up to the preparation of financial
statements. This financial process demonstrates the purpose of
financial accounting–to create useful financial information in the form
of general-purpose financial statements. In other words, the sole
purpose of recording transactions and keeping track of expenses and
revenues is turn this data into meaning financial information by
presenting it in the form of a balance sheet, income statement,
statement of owner’s equity, and statement of cash flows.

The accounting cycle is a set of steps that are repeated in the same
order every period. The culmination of these steps is the preparation of
financial statements. Some companies prepare financial statements on
a quarterly basis whereas other companies prepare them annually. This
means that quarterly companies complete one entire accounting cycle
every three months while annual companies only complete one
accounting cycle per year.

This cycle starts with a business event. Bookkeepers analyze the

transaction and record it in the general journal with a journal entry.
The debits and credits from the journal are then posted to the general
ledger where an unadjusted trial balance can be prepared.

After accountants and management analyze the balances on the

unadjusted trial balance, they can then make end of period adjustments
like depreciation expense and expense accruals. These adjusted journal
entries are posted to the trial balance turning it into an adjusted trial
balance.

Now that all the end of the year adjustments are made and the adjusted
trial balance matches the subsidiary accounts, financial statements can
be prepared. After financial statements are published and released to
the public, the company can close its books for the period. Closing
entries are made and posted to the post closing trial balance.

At the start of the next accounting period, occasionally reversing

journal entries are made to cancel out the accrual entries made in the
previous period. After the reversing entries are posted, the accounting
cycle starts all over again with the occurrence of a new business
transaction.

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Here are the main steps in the traditional accounting cycle.

1. Identification of events to be recorded

The accounting process starts with identifying and analyzing business

transactions and events. Not all transactions and events are entered
into the accounting system. Only those that pertain to the business
entity are included in the process.

First, the business transaction has to be identified. Obviously, if you

don’t know a transaction occurred, you can’t record one. After an
event is identified to have an economic impact on the accounting
equation, the business event must be analyzed to see how the
transaction changed the accounting equation.

2. Journalizing of Transactions

After the business event is identified and analyzed, it can be recorded.

Journal entries use debits and credits to record the changes of the
accounting equation in the general journal. Traditional journal entry
format dictates that debited accounts are listed before credited
accounts. Each journal entry is also accompanied by the transaction
date, title, and description of the event. Here is an example of how the
vehicle purchase would be recorded.

Since there are so many different types of business transactions,

accountants usually categorize them and record them in separate
journal to help keep track of business events. For instance, cash was
used to purchase this vehicle, so this transaction would most likely be
recorded in the cash disbursements journal. There are numerous other
journals like the sales journal, purchases journal, and accounts
receivable journal.

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3. Posting to the General Ledger

The Ledger is also known as the book of final entries, it is a collection

of accounts that shows the changes made to each account as a result of
past transactions, and their current balances.

Ledger accounts use the T-account format to display the balances in

each account. Each journal entry is transferred from the general
journal to the corresponding T-account. The debits are always
transferred to the left side and the credits are always transferred to the
right side of T-accounts.

Since most accounts will be affected by multiple journal entries and

transactions, there are usually several numbers in both the debit and
credit columns. Account balances are always calculated at the bottom
of each T-account. Notice that these are account balances—not column
balances. The total difference between the debit and credit columns
will be displayed on the bottom of the corresponding side. In other
words, an account with a credit balance will have a total on the bottom
of the right side of the account.

After the posting all transactions to the ledger, the balances of each
account can now be determined.

4. Preparation of Unadjusted Trial Balance

An unadjusted trial balance is a listing of all the business accounts that

are going to appear on the financial statements before year-end
adjusting journal entries are made. That is why this trial balance is
called unadjusted.

An unadjusted trial balance is displayed in three columns: a column

for account names, debits, and credits. Accounts with debit balances
are listed in the left column and accounts with credit balances are
listed on the right.

Accounts are usually listed in order of their account number. Most

charts of accounts are numbered in balance sheet order, so the
unadjusted trial balance also displays the account numbers in balance
sheet order starting with the assets, liabilities, and equity accounts and
ending with income and expense accounts.

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Both the debit and credit columns are calculated at the bottom of a trial
balance. As with the accounting equation, these debit and credit totals
must always be equal. If they aren’t equal, the trial balance was
prepared incorrectly or the journal entries weren’t transferred to the
ledger accounts accurately.

As with all financial reports, trial balances are always prepared with a
heading. Typically, the heading consists of three lines containing the
company name, name of the trial balance, and date of the reporting
period.

5. Adjusting Entries

Adjusting entries, also called adjusting journal entries, are journal

entries made at the end of a period to correct accounts before the
financial statements are prepared. This is the fourth step in the
accounting cycle. Adjusting entries are most commonly used in
accordance with the matching principle to match revenue and expenses
in the period in which they occur.

Here are the main financial transactions that adjusting journal entries
are used to record at the end of a period.

Prepaid expenses or unearned revenues – Prepaid expenses are goods

or services that have been paid for by a company but have not been
consumed yet. Insurance is a good example of a prepaid expense.
Insurance is usually prepaid at least six months. This means the
company pays for the insurance but doesn’t actually get the full benefit
of the insurance contract until the end of the six-month period. This
transaction is recorded as a prepayment until the expenses are
incurred. The same is true at the end of an accounting period. Only
expenses that are incurred are recorded, the rest are booked as prepaid
expenses.

Unearned revenues are also recorded because these consist of income

received from customers, but no goods or services have been provided
to them. In this sense, the company owes the customers a good or
service and must record the liability in the current period until the
goods or services are provided.

Accrued expenses and accrued revenues – Many times companies will

incur expenses but won’t have to pay for them until the next month.
Utility bills are a good example. December’s electric bill is always due
in January. Since the expense was incurred in December, it must be

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recorded in December regardless of whether it was paid or not. In this

sense, the expense is accrued or shown as a liability in December until
it is paid.

Non-cash expenses – Adjusting journal entries are also used to record

paper expenses like depreciation, amortization, and depletion. These
expenses are often recorded at the end of period because they are
usually calculated on a period basis. For example, depreciation is
usually calculated on an annual basis. Thus, it is recorded at the end of
the year. This also relates to the matching principle where the assets
are used during the year and written off after they are used.

6. Preparation of Adjusted Trial Balance

An adjusted trial balance may be prepared after adjusting entries are

made and before the financial statements are prepared. This is to test if
the debits are equal to credits after adjusting entries are made

An adjusted trial balance is formatted exactly like an unadjusted trial

balance. Three columns are used to display the account names, debits,
and credits with the debit balances listed in the left column and the
credit balances are listed on the right.

Like the unadjusted trial balance, the adjusted trial balance accounts
are usually listed in order of their account number or in balance sheet
order starting with the assets, liabilities, and equity accounts and
ending with income and expense accounts.

Both the debit and credit columns are calculated at the bottom of a trial
balance. As with the accounting equation, these debit and credit totals
must always be equal. If they aren’t equal, the trial balance was
prepared incorrectly or the journal entries weren’t transferred to the
ledger accounts accurately.

As with all financial reports, trial balances are always prepared with a
heading. Typically, the heading consists of three lines containing the
company name, name of the trial balance, and date of the reporting
period.

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7. Preparation of Financial Statements

Preparing financial statements is the most important step in the

accounting cycle because it represents the purpose of financial
accounting.

In other words, the concept financial reporting and the process of the
accounting cycle are focused on providing external users with useful
information in the form of financial statements. These statements are
the end product of the accounting system in any company. Basically,
preparing these statements is what financial accounting is all about.

Preparing general-purpose financial statements can be simple or

complex depending on the size of the company. Some statements need
footnote disclosures while other can be presented without any. Details
like this generally depend on the purpose of the financial statements.

Financial statements are prepared by transferring the account balances

on the adjusted trial balance to a set of financial statement templates.

8. Closing Journal Entries

Closing entries, also called closing journal entries, are entries made at
the end of an accounting period to zero out all temporary accounts and
transfer their balances to permanent accounts. In other words, the
temporary accounts are closed or reset at the end of the year. This is
commonly referred to as closing the books.

Permanent accounts are balance sheet accounts that track the activities
that last longer than an accounting period. For example, a vehicle
account is a fixed asset account that is recorded on the balance. The
vehicle will provide benefits for the company in future years, so it is
considered a permanent account.

At the end of the year, all the temporary accounts must be closed or
reset, so the beginning of the following year will have a clean balance
to start with. In other words, revenue, expense, and withdrawal
accounts always have a zero balance at the start of the year because
they are always closed at the end of the previous year. This concept is
consistent with the matching principle.

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9. Preparation of a Post-closing Trial Balance

The post closing trial balance is a list of all accounts and their balances
after the closing entries have been journalized and posted to the ledger.
In other words, the post closing trial balance is a list of accounts or
permanent accounts that still have balances after the closing entries
have been made.

This accounts list is identical to the accounts presented on the balance

sheet. This makes sense because all of the income statement accounts
have been closed and no longer have a current balance. The purpose of
preparing the post closing trial balance is verify that all temporary
accounts have been closed properly and the total debits and credits in
the accounting system equal after the closing entries have been made.

A post closing trial balance is formatted the same as the other trial
balances in the accounting cycle displaying in three columns: a column
for account names, debits, and credits.

Since only balance sheet accounts are listed on this trial balance, they
are presented in balance sheet order starting with assets, liabilities, and
ending with equity.

As with the unadjusted and adjusted trial balances, both the debit and
credit columns are calculated at the bottom of a trial balance. If these
columns aren’t equal, the trial balance was prepared incorrectly or the
closing entries weren’t transferred to the ledger accounts accurately.

As with all financial reports, trial balances are always prepared with a
heading. Typically, the heading consists of three lines containing the
company name, name of the trial balance, and date of the reporting
period.

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10. Reversing Journal Entries

Reversing entries, or reversing journal entries, are journal entries made

at the beginning of an accounting period to reverse or cancel out
adjusting journal entries made at the end of the previous accounting
period. This is the last step in the accounting cycle.

Reversing entries are made because previous year accruals and

prepayments will be paid off or used during the new year and no
longer need to be recorded as liabilities and assets. These entries are
optional depending on whether or not there are adjusting journal
entries that need to be reversed.

Reversing entries are usually made to simplify bookkeeping in the new

year. For example, if an accrued expense was recorded in the previous
year, the bookkeeper or accountant can reverse this entry and account
for the expense in the new year when it is paid. The reversing entry
erases the prior year’s accrual and the bookkeeper doesn’t have to
worry about it.

If the bookkeeper doesn’t reverse this accrual enter, he must remember

the amount of expense that was previously recorded in the prior year’s
adjusting entry and only account for the new portion of the expenses
incurred. He can’t record the entire expense when it is paid because
some of it was already recorded. He would be double counting the
expense.

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2.2 Financial Statements

Financial statements are reports that outline the financial activities of a
business. These are meant to present the financial information of the
entity as clearly and concisely as possible for both the entity itself and
for other users of the financial information.

Financial statements are needed by several people and business enties

for these things provide valuable information about the financial
position and the financial performance as well as the cash flows of an
entity that is useful to a wide range of users in making economic
decisions (Valix, 2015).

The elements of financial statement include the financial position and

financial performance. Whn we talk about financial position, this
refers to the status of the assets, liabilities, and owners' equity while
the financial performance refers to the subjective measure of how well
a business entity utilizes its assets to generate revenues.

A complete set of financial statements comprises an Income

Statement, Statement of Comprehensive Income, Statement of
Changes in Equity, Statement of Financial Position, Statement of Cash
Flows and Notes to Financial Statements.

Income Statement

It is a financial Statement that gives the result of the business operation

or financial performance of a business for a given period. Its elements
include income or revenue, costs, expenses and net profit or loss.

Statement of Comprehensive Income

This includes the profit or loss elements of income statement with an

additional component for other comprehensive income. This
additional component includes items of income and expense or gains
and losses from reclassification adjustments that are not recognized in
the income statement.

Statement of Changes in Equity

It is a financial statement that shows the movements in equity accounts

at a given period of time. Its elements are the beginning capital, net
income/loss, additional investments, owner’s withdrawals and the
ending capital.

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Statement of Financial Position

This type of financial statement is also known as the balance sheet. It

is a document that shows the financial position or financial condition
of a business for a given period of time. It can reflect an entity’s
financial structure, liquidity and solvency. Its elements include Assets,
Liabilities and Equity.

Statement of Cash Flows

This financial statement summarizes the operating activities, investing

activities as well as the financing activities of an entity. It provides a
list of information about cash receipts and cash disbursements of an
entity at a given period of time.

Notes to Financial Statements

These are additional notes which are usually placed at the last part of
the compilation of financial statements. This describes the summary
of significant accounting policies adopted by the business entity and
other important explanatory information regarding the things stated in
the other financial statements. This statement provides a narrative
description or disaggregation of items presented in the financial
statements and information about items that do not qualify for
recognition since these items are non-accountable or not quantifiable.

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Glossary
Accounting Cycle - refers to a series of sequential steps performed to
accomplish the accounting process

Financial statements - records that outline the financial activities of a

business, an individual or any other entity

References
C. Valix and C.A. Valix, (2015). ―Theory of Accounts‖, GIC Enterprises &
Co. Inc.

R.S. Roque, (2013). ―Management Advisory Services‖, GIC Enterprises &

Co. Inc.

Investopedia, (2016).

My Accounting Course, (2016).

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