The Accounting Cycle

In the typical accounting system, raw data are transformed into financial statements in five steps. The first three – analysis, journalizing, and posting – are performed on a continual basis throughout the accounting period. The last two – preparation of the trial balance and of the financial statements – are performed at the end of the accounting period.

Analyzing Source Documents The basic accounting data are contained in source documents, which are the receipts, invoices, cash register tapes, sales slips, and other documents that show the dollar values of day-to-day business transactions. The accounting cycle begins with the analysis of each of these documents. The purpose of the analysis is to determine which accounts are affected by the documents and how are they affected.

Journalizing the Transactions Every financial transaction is next recorded in a journal – a process that is called journalizing. Transactions must be recorded in the firm’s general journal or in specialized journals. The general journal is a book of original entry in which typical transactions are recorded in order of their occurrence. An accounting system may also include specialized journals for specific types of transactions that occur frequently. Thus a retail store might have cash receipts, cash disbursements, purchases, and sales journals in addition to its general journal.

Posting Transactions Next the information recorded in the general journal or specialized journals is transferred to the general ledger. The general ledger is a book of accounts that contains a separate sheet or section for each account. An account is a form used to sort and summarize changes in a specific item. Separate accounts for each item may be kept on cards, sheets, or in bound book form.

Ledger accounts are a means of accumulating in one place all the information about changes in specific assets, liabilities, and owner’s equity. In its simplest form, an account has only three elements: (1) a title, consisting of the name of a particular asset, liability, or owner’s equity; (2) a left side, which is called a debit side; and (3) a right side, which is called a credit side. This form of account is called a T account because of its resemblance to the letter T.

An amount recorded on the left or debit side of an account is called a debit, or a debit entry; an amount entered on the right or credit side is called a credit, or a credit entry. Accountants also use the words debit and credit as verbs. The act of recording a debit in an account is called debiting the account; the recording of credit is called crediting the account. A debit to an account is sometimes called a charge to the account; an account is debited or charged when an amount is entered on the left side of the account.

Students beginning a course in accounting often have a preconceived but erroneous opinion about the meanings of the terms debit and credit. For example, to some people unacquainted with accounting, the word credit may carry a more favourable connotation than does the word credit. Such connotations have no validity in the field of accounting. Accountants use debit to mean an entry on the left-hand side of an account, and credit to mean an entry on the right-hand side. The students should therefore regard debit and credit as simple equivalents of left and right, without any hidden or subtle implication.

The process of transferring journal entries to the general ledger is called posting.

Accounts are usually arranged in the ledger in financial statement order, that is, assets first, followed by liabilities, owner’s equity, revenue, and expenses. The number of accounts needed by a business will depend on its size, the nature of its operations, and the extend to which management and regulatory agencies want detailed classification of information. An identification number is assigned to each account. A chart of accounts is a list of the accounts titles and account numbers being used by a given business.

Preparing the Trial Balance The trial balance is a summary of the balances of all general ledger accounts at the end of the accounting period. After all transactions for the period have been posted to the ledger accounts, the balance for each account is determined. Every account will have either a debit, credit or zero balance. A trial balance is a list of each account balance and it, therefore, indicates whether in total the debits equal the credits. Thus a trial balance helps provide a check on the accuracy of the recording and posting. It does not, however, guarantee that the recording and posting have been done correctly. Errors, such as posting an amount to the wrong account, are of course possible even though the trial balance does balance.

Preparing Financial Statements and Closing Books The firm’s financial statements are prepared from the information contained in the trial balance. This information is presented in a standardized format to make the statements as generally accessible as possible to the various parties who may be interested in the firm’s financial affairs.

Once these statements have been prepared and checked, the firm’s books are “closed” for the accounting period. A new accounting cycle is then begun for the next period.