In this lesson, we’re going to take a closer look at what’s called the Accounting Cycle. This will help you understand the overall flow of accounting information during an organization’s fiscal period, as well as the routine accounting activities that are performed from the end of one period through to the beginning of the next.
We’ll start with a high-level view of the accounting cycle, to get our bearings. Then we’ll zoom down into the low-level details, where you’ll learn how to figure out the various kinds of journal entries that are made during an accounting cycle. Finally, I’m going to introduce you to an exercise that is available on the course website if you are interested in developing your accounting skills.
Overview of the Accounting Cycle
Let’s look at the big picture, then. What kinds of activities take place during the accounting cycle, and what takes place at the end, when things get hectic.
Here is a graphic representation of the accounting cycle. You may recall the sequence of activities that we talked about in the bookkeeping lesson, when we talked about recording, organizing, and presenting accounting information. We can now add one more minor, technical procedure to that list, which is closing the fiscal period. This procedure is completely internal to the accounting system, and we’ll be going over it in detail in this lesson. It’s what closes the loop from the end of one period to the beginning of the next.
1. Opening Balances
The accounting cycle starts with the opening balances of all the accounts. The permanent accounts on the balance sheet will typically have non-zero balances. Asset accounts will normally have debit balances, because, for example, the inventory at the end of the last period is still there at the beginning of the new one. Liability and equity accounts will normally have credit balances, because bank loans and accounts payable and share capital and retained earnings are all carried forward from one period to the next. There can be exceptions to these “normal” balances, of course. You might be overdrawn at the bank and have a credit balance in your cash account, or you might have had a series of losses that have led to a debit balance in your retained earnings account, but such a situation would not be considered normal.
The temporary accounts, including all the revenue and expense accounts that are used to create the income statement, will all have balances of zero at the beginning of the fiscal period, because they were cleared out at the end of the one.
2. Record Transactions
Recording the transactions in a journal takes most of the time during the fiscal period, because that happens over and over again. The company has to capture every economic exchange that take place during the fiscal period between them and other organizations or individuals, so this includes sales, purchases, lease payments, employee wages, and so on.
Every other step that’s listed here takes place only once, at the end of the fiscal period.
3. Post Transactions
Posting the transaction entries to the ledger means organizing all the debits and credits of the transactions into accounts. We went over this in some detail in the bookkeeping video, so if you missed that, you might want to go back and watch it.
4. Prepare Trial Balance
Preparing the trial balance simply means listing all the debit and credit balances of every account. This is crucial if you are keeping your books by hand, but it’s trivial in any computerized accounting system. The trial balance helps confirm that all the account balances are as the accountant expects, but it doesn’t provide the fine detail needed to catch and fix small errors.
5. Post Adjusting Entries
Next is the posting of the adjusting entries. This includes all the accrual transactions to mark the passage of time: amortization of intangible assets, depreciation of equipment, accrual of interest on loans, accrual of employee wages for any hours worked since the last pay date, and so on. This would be when any corrections would be posted, too, if the accountants found any errors in the journals.
6. Prepare Adjusted Trial Balance
After the adjusting entries have been posted, another trial balance is prepared, to get a final list of the account balances.
7. Publish Financial Statements
Once that is done, the company can publish its financial statements. They will reflect all the transactions that happened during the fiscal period, plus all the accruals at the end of the period – the adjusting entries that account for the passage of time.
8. Post Closing Entries
The final step is to close the fiscal period. This is a big journal entry that transfers the balances of all the temporary accounts that were used during the fiscal period, to the relevant permanent accounts on the balance sheet. Primarily, this means transferring the revenue and expenses to the retained earnings account in the equity section, leaving the revenue and expense accounts ready for the next fiscal period.
Year-End Dates
Every company and organization complete this cycle at least once a year. For small businesses and small non-profit organizations, that might be it. Larger organizations, though, including all the publicly traded companies, complete the accounting cycle every quarter, so every three months. This allows them to present their financial statements to the world on an interim basis three times during the year, at the three-month, six-month, and nine-month marks, followed by a final set of financial statements at the end of the year. Only the final set, the year-end statements, would be audited, because auditing is expensive.
The date of the fiscal year-end, by the way, differs from company to company. By convention, almost all companies in the world pick one of four dates: the last day of March, the last day of June, the last day of September, or the last day of December. They could in theory pick a different date, but there’s no good reason for a company to stand out from the crowd on such a trivial matter.
The choice of one of these four dates mainly depends on the preferences of the board of directors when the company was founded. The very first year end date might be chosen to coincide with the year end of other companies in the industry. This means that the first fiscal year might not be a full 12 months. Say a company is formed in February and decides on a September 30th year end: its first set of financial statements would only cover eight months, but after that, the company would stick with the same year-end date, and all of the subsequent fiscal periods would be 12 months long.
It’s possible to change a company’s year end, by the way, but it’s messy so you really have to have a strong reason for doing it, like going public, or a merger that is going to disrupt the company’s financial results anyway. Many companies never change their fiscal year end.
The Opportunity to Tinker
One more thing: When I say that these steps take place “at the end of the fiscal period,” I just mean relatively soon after the last day of the fiscal period, say within six or eight weeks. The financial statements that are produced represent the situation of the company at the year-end, but the key accounting decisions that affect those statements are made looking back at the fiscal period that has just ended. This means that adjusting entries can be used to tinker with the company’s financial results. We’ll discuss this in the lesson on earnings management.
Even if the managers don’t engage in any tinkering, large, publicly traded companies have to make a trade-off on how much time to take getting the adjusting entries right. If they rush their statements out the door, their adjusting entries will require more estimation because the managers will be missing the information that continues to trickle in after the year end, such as whether customer A is going to dispute an invoice, or whether the damage to a truck is as bad as it looks. This means that rushing the statements makes them less accurate. However, waiting for complete and perfect information would be self-defeating because that would delay the statements and make them less relevant to all the people who have been waiting for them.
Some Details
Let’s take a bit of a closer look at a few key parts of the accounting cycle, namely the transaction entries, adjusting entries, publishing the financial statements, and the closing entries. This is not going to be as detailed as the bookkeeping video, but it will help you make connections between the things we talked about in that lesson and key steps of the accounting cycle.
Recording
The transaction entries are a type of journal entry. These are the combinations of debits and credits that record economic exchanges between the company and other organizations and individuals.
The most common transaction for most companies is the sales transaction. We’ll be talking about how to recognize revenue and expenses in an upcoming lesson, but suffice to say, every company has to have a consistent policy on when to recognize a sale and how to recognize the expenses that were incurred to make that sale possible. It can get quite complicated when you start to think about things like returns of items a customer doesn’t want, or warranty claims.
There are plenty of other economic exchanges to record, of course, that aren’t related to sales. Think about buying new furniture for the office, or selling an old truck. Think about borrowing money from the bank, or repaying it. Think about paying salaries to the head office employees or dividends to shareholders. All of these transactions need to be captured in the journal.
When you are trying to figure out how to record a transaction, the first thing to remember is that the debits and credits have to balance. This is more of a concern to you as a student than it is to an actual bookkeeper, because the bookkeeper is probably using an accounting application that won’t allow transactions to be out of balance. If you are writing out a transaction on an accounting exam, though, you have to take the time to check to see that all the debits and all the credits add up to the same amount.
The second thing to think about is which part of the transaction is the most obvious. If you paid for something, you know right away that cash went down, so that’s a credit to cash. If a customer paid you, then that has to be a debit to cash.
If it wasn’t a transaction that involved cash, it probably involves something else just as obvious, like a happy customer walking away with some of your inventory. That’s got to be a credit to inventory.
Figuring out the other side of the transaction might take some careful thought, particularly if you are new at accounting. This is normal. You are learning a new language, after all.
Just narrow things down one step at a time. Which statement will the other side of the transaction appear on: the balance sheet or the income statement? If you’ve already got a credit to cash figured out, for instance, is the thing that you got in exchange another asset, like a truck, or is it an expense, like rent? Or maybe you used the cash to clear a liability of some kind, like wages payable or a bank loan.
Once you have decided which statement is affected, you need to think about where on the statement the effect will be seen. Is it a current asset or a fixed asset? Is it cost of goods sold or some other operating expense?
Then you just have to pick the right account.
Admittedly, this is a process that requires lots of practice to get right – but once you get used to recording journal entries, it becomes routine.
Adjusting
The adjusting entries are the ones that adjust the value of assets and liabilities to account for the passage of time. Wear and tear has occurred on your truck. Another month of your insurance policy has expired. Your employees have worked for the four days between the last biweekly pay date and the end of the month. Interest has accumulated on your bank loan.
Note that none of these examples involve cash changing hands. It’s not about paying your employees, but recognizing that you owe them four days of wages. It’s not about paying the bank, but recording the interest that the bank has charged you this month, even though the loan payment isn’t due until sometime next month.
And finally, note that every example involves both the income statement and the balance sheet. The book value of your truck asset goes down on the balance sheet, and there is a new depreciation expense on your income statement. Lots of regular transactions also affect both the income statement and the balance sheet, but not all of them. Purchasing a truck or taking out a bank loan doesn’t affect the income statement. Adjusting entries, however, always have one side that affects a balance sheet account and one side that affects an income statement account.
Figuring out adjusting entries is easier in one respect than figuring out transaction entries, because you already know which balance sheet account is affected. That’s the account that you are adjusting: the value of the truck, or the amount of interest you owe the bank.
The other side of the adjusting entry has to be on the income statement, and it has to keep the balance sheet in balance. If an asset went down in value, that’s a credit, because assets normally have a debit balance. The other side of the entry will therefore be a debit, which means that it will show up on the income statement as an expense. This is going to cause the retained earnings calculation to go down on the balance sheet. That keeps everything in balance.
The trickiest part of figuring out an adjusting entry is the amount. For transaction entries, the amount is given to you: you know the price you paid for the photocopy paper at the office supplies store. For adjusting entries, the amount has to be calculated. It might be 1/12th of the prepaid insurance, or you might have to calculate interest on your loan. These are not impossibly hard, but they do require you to think about what you are doing.
Once you’ve got the adjusting entry figured out, posting it is the easy part. Just make sure the debits and credits balance!
I’ve listed several examples of adjusting entries here. We’ll cover all of these in more detail later in the course, but for now, this helps you see that some adjusting entries affect assets and some affect liabilities. Some affect revenue and some affect expenses. Every asset or liability that is affected by the passage of time – and that is most of them – will be adjusted at the end of each fiscal period.
Publishing
Publishing the financial statements is the easiest part of an accountants job, if they are using a computer. It’s just a matter of pushing a button. Doing it by hand is much harder, because financial statements involve a lot of summarizing and conflating. Some disclosures are mandatory, but that doesn’t mean every company discloses the mandatory information in the same way. Some might display their cost of goods sold clearly on the second line of the income statement, others might bury that information deep in the notes to the financial statements. Every account has to contribute to the totals on these statements one way or another, but most accounts are added together with others accounts to create a low-resolution picture of the corporation.
There will be logic in the grouping together of accounts. All the prepaid expenses will go together, all the fixed assets will go together, all the long-term debts will go together, and so on. But there is no requirement to provide a detailed breakdown of the fixed assets. “Property, plant and equipment” is sufficiently vague to suit the needs of many companies.
The decisions on these groupings are made by senior management, subject to rules about mandatory disclosures that are imposed by the financial markets, assuming the company is publicly traded. The auditors will ensure, to the exact degree that auditors ensure anything, that the accounts are all classified correctly. You’re not likely to find an expense account being added to the current liabilities section of the balance sheet.
A company’s financial statements are prepared by the senior managers, with the help of accountants. The statements are audited, also by accountants. And the ultimate responsibility for the statements rests with the board of directors, many of whom will be accountants. You may wish to take this pattern as reassuring. But when things go wrong, and they do, you might also wish to think that the accounting profession has a lot to answer for.
Closing
The closing entries are fairly straightforward. It’s simply a matter of applying a debit to every temporary account that has a credit balance, and applying a credit to every temporary account that has a debit balance, and then putting a suitable debit or credit into the relevant permanent account to make the whole transaction balance.
When you are closing the revenue and expense accounts, you’ll put debits into the revenue accounts to bring their balance to zero, then credits into the various expense accounts to bring their balances to zero, and then finally put a credit into retained earnings to make the transaction balance. Because revenue minus expenses equals the net income, the credit to retained earnings will be the same amount as the net income. A credit to retained earnings makes equity go up. And of course, if there was a loss on the income statement instead of a profit, there won’t be a credit to retained earnings, there will be a debit, and equity will go down.
These aren’t the only temporary accounts, but they are the main ones. There are also temporary accounts used for things like declaring dividends or recording all the inventory purchases. These just help the accountants keep track of what happened during the fiscal period. They all need to be closed to the relevant account.
Once the closing entries are posted, the details in the temporary accounts can be archived somewhere for future reference, and then purged from the active accounts so that the next period can begin afresh.
There is nothing mysterious about the closing entry. Just apply the necessary debit or credit to bring each revenue or expense account balance to zero. Do the same for the “dividends declared” account, which actually doesn’t show on the income statement, but rather on the statement of changes in retained earnings. (Remember those linking statements that I mentioned in a previous video. That was one of them.) The balancing entry will go to retained earnings.
In the example shown, net income for the year was $300,000 ($700,000 minus $400,000), and dividends were $100,000, leading to an increase of $200,000 in retained earnings for the year. If you tried to print the financial statements after the closing entry, the balance sheet would look perfectly fine, but the income statement would be all zeroes.
Exercise: Cooked Books Inc.
There is really only one way to get this stuff to sink in, and that’s to practice it. So, please take the time to complete the following exercises. There are two downloadable files:
Click to download
One is a Word document describing various events for a pretend business called “Cooked Books Inc.” You need to write out transactions to record each event, and then prepare the adjusting and closing entries for the fiscal period.
Click to download
The other document is an Excel worksheet where you will enter the transactions and the adjusting entries, to produce financial statements for the company. (The worksheet doesn’t ask you to enter the closing entry that you prepared.)
The Excel spreadsheet is an alternative way of recording accounting transactions, using adding and subtracting instead of debits and credits. If you find it too confusing after wrapping your head around debits and credits, don’t worry. The spreadsheet method is not suitable for a real business, but it can often help students understand the relationship between the income statement and the balance sheet, or “Statement of Financial Position.”
Download the files and have a crack at completing the exercise. I highly recommend it. You can listen to me explain financial accounting all day long, but until you practice it yourself, you won’t develop your own sense of how the underlying calculations work in financial accounting.
Completed versions of the documents are available at the bottom of this page. Use them if you want to check your work, but don’t pretend that reading them is any kind of substitute for attempting the exercises yourself. Learning doesn’t work that way, particularly for adult learners.
Summary
Let’s review what we have covered in this lesson.
We’ve gone over the accounting cycle, both at a high level and in detail.
We’ve learned the difference between transaction entries, adjusting entries, and closing entries, and we’ve seen how the accounting cycle positions everything so that the financial statements can be published just before the closing entry is done to wrap things up and clear the slate for the next financial period.
You have also, I hope, attempted the Cooked Books bookkeeping exercise. I hope you found it useful.
When you are ready, on to the next lesson!
Title photo: generators from the old powerplant at Kagawong, on Manitoulin Island