One Full Accounting Cycle Process Explained

[Basic]

Although, in theory, the basic accounting equation can be used to prepare

financial statements, virtually all firms would find that approach to be extremely
cumbersome. Far more efficient processes are needed by firms that have
hundreds of different assets and liabilities and engage in thousands of
transactions. This post simply summarizes the detailed procedures used by
accountants to generate financial statements [the basic way]. Enjoy!

The accounting process includes the steps summarized:

• Identify transactions and events.

• Analyze transactions and events in terms of the basic accounting equation.
• Translate the transaction analysis into debits and credits.
• Prepare journal entries and post to the general ledger.
• Prepare and post adjusting entries.
• Prepare the income statement.
• Prepare and post closing entries.
• Prepare the balance sheet.

The General Ledger

The core of financial accounting is the analysis of transactions in terms of the

basic accounting equation:

Assets = Liabilities + Shareholder’s Equity

The purpose of this analysis is to summarize the effects of different types of

transactions on the equation’s elements. In real business settings, this
summarization is done in the general ledger. Although most accounting systems
are computerized, at this stage we will illustrate a manual system. In such a system,
the general ledger often takes the form of a loose-leaf notebook. Each page is
assigned to a particular equation item [such as cash, inventory, accounts payable, or
invested capital] and is referred to as an account.
Debits and Credits

To show increases and decreases in account amounts, plus (+) and minus (–)
signs could be used. For several reasons, however, the accounting profession has
discarded this alternative. Instead, each account is divided into a left-hand side and
a right-hand side; increases are recorded on one side and decreases are recorded on
the other.

For all accounts, the left-hand side is the debit side and the right-hand side is the
credit side. For accountants, debit and credit have no meanings other than left
and right, respectively. This can be a source of confusion. Many non-accountants
associate the term credit with something good. The accountant does not.

In actual business practice, general ledger accounts can take many forms. In
educational world [and for simplicity], they are illustrated mostly using T-
accounts.

The side of an account in which increases and decreases are recorded depends on
the nature of the account. Increases in assets are recorded by debits, and
decreases are recorded by credits. The rules for liabilities and shareholders’ equity
are the reverse: increases are recorded as credits, and decreases are recorded as debits.

The debit and credit rules are largely arbitrary. Accordingly, with one exception,
do not look for any special logic in them. One aspect of the rules does make sense,
however. Because assets appear on the opposite side of the basic accounting equation
from liabilities and share holder’s equity, the debit and credit rules for assets are the
opposite of the rules for liabilities and shareholders’ equity.

As an example, consider two illustrative transactions below:

• First, shareholders invest $10,000 in a firm. In terms of the basic equation, this
transaction increases cash and increases shareholder’s equity (invested
capital): In the general ledger, an increase in cash is recorded as a debit, and
an increase in shareholders’ equity is recorded as a credit.
• The second transaction involves a purchase of inventory for $2,000. This
transaction increases inventory and decreases cash: The decrease in cash is
recorded as a credit, and the increase in inventory is recorded as a debit.

As previously mentioned, the rules for assets (which appear on the left side of the
equation) are the opposite of the rules for liabilities and shareholder’s equity
[which appear on the right side of the equation]. This is no coincidence. By
reversing the rules, the equality of debits and credits for each transaction (and in total)
is assured. For example: when inventory is purchased for cash, inventory is debited
and cash is credited for $2,000.

The equality of debits and credits helps accountants identify and eliminate errors
from the accounting process.
Balancing Accounts

To determine the net amount of cash, inventory, and so on at the end of an

accounting period, the accounts must be balanced. This is done by totaling the
debits and credits in each account and calculating their difference. This
difference is shown on the side of the account that has the larger amount. These
balances are the basis for the financial statements.

Chart of Accounts

Firms have a great deal of discretion in choosing their account titles and the
number of accounts they employ. Accordingly, most firms develop a chart of
accounts, which is essentially an index to the general ledger. It lists account titles and
account numbers. Account numbers are often employed because they provide a firm’s
personnel with an efficient and unambiguous way to communicate.

The General Journal

In the general ledger, the information about a given transaction is spread across
two or more accounts. This makes it difficult for auditors and others to review
all the information about a given transaction. The general journal is another
major accounting record. It provides a chronological listing of all transactions and
events. This enables the auditor to easily see all the accounts affected by a single
transaction. As with the general ledger, the general journal in a manual system
consists of a loose-leaf notebook.

Journal Entry [ies]

General journal entries are actually the first step in the formal financial
accounting process. This step occurs after the accountant has conceptually analyzed
the transaction in terms of the basic accounting equation, ascertained which accounts
have increased or decreased, and translated the increases and decreases into debits and
credits.

A transaction’s journal entry consists of:

• the date,
• the account(s) to be debited,
• the account(s) to be credited,
• the amounts, and
• an explanation.
For example: if shareholders invest $10,000 in a firm on January 1, cash is increased
and shareholder’s equity is increased. Translated into debits and credits, cash is
debited and invested capital is credited. In journal entries, the debits are shown first,
and the credits are indented and shown after the debits. The journal entry for the
$10,000 investment would be:

Journal Entry: January 1

[Debit]. Cash = $10,000

[Credit]. Invested Capital = $10,000
[To record shareholder’s investment]

Posting

To determine account balances, the amounts in the journal entries need to be

placed in the general ledger. Transcribing the amounts from journal entries into
the general ledger is called “posting“. From a procedural standpoint, transactions,
events, and so on, are never initially entered into the general ledger. General journal
entries are always prepared first and are then posted to the general ledger.

An Illustration Of Accounting Procedures

Assume that Lie Dharma Putra Inc. began operations in January 2009 and engaged in
a number of transactions. That example is used here to demonstrate the accounting
procedures just discussed.

Transaction 1: Shareholders invest $50,000.

Analysis: Increase cash; increase invested capital.

Debits and credits: Increase cash (an asset) by a debit; increase invested capital (an
equity account) by a credit.

Journal entry: January 1

[Debit]. Cash = $50,000

[Credit]. Invested Capital = $50,000
[To record investment by shareholders]

Transaction 2: Lie Dharma Putra Inc. borrowed $20,000 from a bank.

Analysis: Increase cash; increase notes payable.
Debits and credits: Increase cash by a debit; increase notes payable by a credit.

Journal entry: January 1

[Debit]. Cash = $20,000

[Credit]. Notes Payable = $20,000
[To record note payable]

Transaction 3: Lie Dharma Putra Inc. paid in advance one year’s rent of
$12,000.

Analysis: Increase prepaid rent; decrease cash.

Debits and credits: Increase prepaid rent by a debit; decrease cash by a credit.

Journal entry: January 1

[Debit]. Prepaid Rent = $12,000

[Credit]. Cash = $12,000
[To record prepayment of one year’s rent]

Transaction 4: Purchased inventory on account, $30,000.

Analysis: Increase inventory; increase accounts payable.

Debits and credits: Increase inventory by a debit; increase accounts payable by a
credit.

Journal entry: January 1

[Debit]. Inventory = $30,000

[Credit]. Accounts Payable = $30,000
[To record the purchase of inventory on account]

Transaction 5: Purchased equipment for $25,000.

Analysis: Increase equipment; decrease cash.

Debits and credits: Increase equipment by a debit; decrease cash by a credit.

Journal entry: January 1

[Debit]. Equipment = $25,000

[Credit]. Cash = $25,000
[To record purchase of equipment for cash]
At this point, journal entries have been prepared for all of Lie Dharma Putra
Inc. preliminary transactions. The next step is to post these entries to general
ledger accounts.

Revenue and Expense Accounts

Revenue and expense transactions affect the retained earnings component of

shareholder’s equity. For example: if a firm renders services in the amount of $100
to clients, on account, accounts receivable increases and retained earnings increases:

ASSETS = LIABILITIES + SHAREHOLDER’S EQUITY

Accounts Receivable: +$100

Retained earnings: +$100 [sales]

The income statement summarizes the many types of revenue and expense
transactions that affect retained earnings during a period. If all revenue and
expense transactions were commingled in that one account, ascertaining the
detailed amounts for each line item on the income statement would be quite
difficult. Consequently, general ledger accounts are established for each revenue and
expense item desired on the income statement. Instead of initially debiting or
crediting retained earnings for revenue and expense transactions, the revenue and
expense accounts are used. These accounts are best viewed as temporary accounts,
which are really components of retained earnings. Increases in revenues are shown as
credits, while increases in expenses are treated as debits. Note that expenses reduce
retained earnings; so increasing the debit balance in an expense account actually
decreases retained earnings.

The debit and credit rules for revenue and expense accounts are as follows:

Revenue:
Decreased: Record in Debit side
Increased: Record in Credit side

Expense:
Increased: Record in Debit side
Decreased: Record in Credit side

To illustrate Lie Dharma Putra Inc. revenue and expense transactions for January,
2009, assume that all transactions occur on January 15.
Transaction 6: Rendered services to customers for $200 plus a promised future
payment of $400.

Analysis: Increase cash; increase accounts receivable; increase service revenue.

Debits and credits: Debit cash by $200; debit accounts receivable by $400; credit
service revenue by $600.

Journal Entry: January 15

[Debit]. Cash = $200

[Debit]. Accounts Receivable = $400
[Credit]. Service Revenue = $600
[To record service revenue]

The preceding entry is referred to as a compound journal entry. Its

distinguishing characteristic is that more than one account is either debited or
credited [or both]. As with all journal entries, the total dollar amount of debits equals
the total dollar amount of credits.

Transaction 7: Received $100 from customers for services to be performed at a

later date.

Analysis: Increase cash; increase unearned revenue [remember that unearned revenue
is a liability].
Debits and credits: Debit cash; credit unearned revenue.

Journal entry: January 15

[Debit]. Cash = $100

[Credit]. Unearned revenue = $100
[To record customers’ prepayment of revenue]

Transaction 8: Paid workers’ salaries of $700.

Analysis: Decrease cash; decrease retained earnings via salary expense.

Debits and credits: Credit cash; debit salary expense.

Journal entry: January 15

[Debit]. Salary Expense = $700

[Credit]. Cash = $700
[To record payment of salary expense]
Transaction 9: Received a $120 utility bill for services already used. Payment
was not immediately made.

Analysis: Utilities expense increases; utilities payable increases.

Debits and Credits: Debit utilities expense; credit utilities payable.

Journal entry: January 15

[Debit]. Utilities Expense = $120

[Credit]. Utilities Payable = 120
[To record January utilities expense]

Transaction 10: Sold, for $4,000 on account, inventory costing $2,200.

Analysis: Accounts receivable increases; sales increases; inventory decreases; cost of

goods sold (COGS) increases.
Debits and credits: Debit accounts receivable; credit sales; credit inventory; debit
Cost Of Goods Sold [COGS].

Journal entry: January 15

[Debit]. Accounts Receivable = $4,000

[Credit]. Sales = $4,000
[To record a credit sale on account]

[Debit]. Cost Of Goods Sold = $2,200

[Credit]. Inventory = $2,200
[To record COGS on credit term of sale]

Adjusting Entries

Adjustments to the accounting records are typically needed before financial

statements are prepared. The adjustments are needed to ensure that the account
balances are correct and up to date. These adjustments result from interest
accruals, depreciation, and a variety of other matters. Adjustments to the account
balances are accomplished by journal entries. We now analyze the adjustments
needed to correctly state Lie Dharma Putra Inc’s accounts as of January 31.

Transaction 11: Incurred but did not pay interest expense of $133.

Analysis: Increase interest expense; increase interest payable.

Debits and credits: Debit interest expense; credit interest payable.

Journal entry: January 31

[Debit]. Interest Expense = $133
[Credit]. Interest Payable = $133
[To record January interest expense]

Transaction 12: Used $1,000 of prepaid rent.

Analysis: Increase rent expense; decrease prepaid rent.

Debits and credits: Debit rent expense; credit prepaid rent.

Journal entry: January 31

[Debit]. Rent Expense = $1,000

[Credit]. Prepaid Rent = $1,000
[To record January rent expense]

Transaction 13: Depreciation on equipment amounted to $208.

Analysis: Increase depreciation expense; decrease equipment by increasing the

balance in the contra-asset account, accumulated depreciation.
Debits and credits: Debit depreciation expense; credit accumulated depreciation.

Journal entry: January 31

[Debit]. Depreciation Expense = $208

[Credit]. Accumulated Depreciation = $208
[To record January depreciation expense]

Transaction 14: Earned $50 of the $100 advance payment previously made by
customers.

Analysis: Decrease unearned revenue; increase service revenue.

Debits and credits: Debit unearned revenue; credit service revenue.

Journal entry: January 31

[Debit]. Unearned Revenue = $50

[Credit]. Service Revenue = $50
[To record revenue earned]

The balances in the revenue and expense General ledger accounts should be
correct now and the income statement.
Closing Entry [ies]

At this point, a problem exists in preparing Lie Dharma Putra Inc’s balance
sheet. Since the revenue and expense transactions, which really affect retained
earnings, were not recorded in that account, the balance sheet will not balance.
Therefore, the amounts in the revenue and expense accounts must be transferred
to retained earnings. This is done via closing entries.

Lie Dharma Putra Inc’s closing entries at the end of January appear. Viewed in
isolation, closing entries do not make a great deal of sense. However, keep in mind
their purpose: to transfer balances from revenue and expense accounts to retained
earnings.

The balance now in retained earnings is that which would have been there if all the
revenue and expense transactions were initially recorded in that account.

Note that after posting the closing entries, the balance in each revenue and expense
account is zero. This is why they are called temporary (or nominal) accounts.
Moreover, since the balances are zero, next month they will only reflect the revenue
and expense amounts for February and not a cumulative amount beginning with
January. This will enable the easy preparation of an income statement for the month
of February.

Dividends

Lie Dharma Putra Inc. engaged in one more transaction in January. It declared and
paid a $100 dividend to the shareholders. The analyses are as follows:

Transaction 17: Paid dividend of $100.

Analysis: Cash decreases; retained earnings decreases.

Debits and credits: Debit retained earnings; credit cash.

Journal entry: January 31

[Debit]. Retained earnings = $100

[Credit]. Cash = $100
[To record dividend]

The posting of this entry is also reflected in the general ledger accounts. At this
point, all transactions have been journalized and posted, and the revenue and expense
accounts have been closed to retained earnings. A balance sheet based on the account
balances can be prepared.

Preparing general journal entries for each transaction is a laborious, time-

consuming process; account titles must be written and often the same amount
must be written twice in the same entry. Because of this, accountants have
devised streamlined journalizing procedures that make use of special journals.
Special journals are constructed to achieve great efficiencies in journalizing
transactions. Examples of special journals include sales journals, cash receipts
journals, and cash payments journals.