THE ACCOUNTING CYCLE
1. THE ACCOUNTING CYCLE
Accounting cycle refers to certain procedures performed in a systematic
manner for a given period to provide data to be reported in the financial
statements. It starts with collecting data about economic events (business
transactions) and ends with preparing reversing entries.
1.1 SEQUENCE OF ACCOUNTING CYCLE
1. Collecting data about economic events
Data about economic events are collected from source documents. A
source documents provides evidence that an economic event has occurred.
Examples of source documents are sales invoices, official receipts,
purchase order, delivery receipt, cash register tapes, daily-time record.
2. Analyzing data about economic events
Once economic data are collected through source documents, the next step
is to analyze the data to determine the effects of relevant economic events
on the company’s financial statement elements.
3. Journalizing the transactions
Transactions are recorded in a journal, also called the book of original
entry. It provides a chronological record of events that affect the company.
4. Posting to the ledger
Posting of debit and credit from the journal to the proper ledger accounts,
thus creating a record classified by accounts. The ledger is also called
book of final entry.
5. Preparing the trial balance
This proves the equality of debit balances and credit balances in the
ledger.
6. Adjusting of accounts
Preparation of adjusting entries is made to bring financial data up-to-date.
A worksheet is usually prepared to facilitate the preparation of adjusting
entries, financial statements, and closing entries.
7. Preparing the adjusted trial balance
This again is prepared to prove the equality of debits and credits after
adjustments have been posted.
8. Preparing the financial statements
Income statement, balance sheet, statement of cash flows are then prepared
based on the adjusted trial balance.
9. Journalizing and posting of closing entries
The closing entries bring the revenue and expense accounts to “zero” in
order to prepare the books to record new transactions or events in the next
accounting period.
10. Preparing the post closing trial balance
This step ensures that the ledger remains in balance after posting the
closing entries.
11. Preparing reversing entries
Certain accounts that were adjusted are reversed in the next accounting
period.
1.2 JOURNALIZING THE TRANSACTIONS
TYPES OF JOURNAL
1. General Journal
simplest form of journal that wherein the two-column form is
used.
2. Special Journal
a journal designed for quickly and efficiently recording one
particular type of transaction. Examples are cash receipts journal,
sales journal, purchases journal, cash payment journal.
PARTS OF JOURNAL ENTRY
1. Date
This is the date when the transaction was consummated. This date
will be used in recording the transactions in the general journal.
2. Account Titles and Explanation
3. Amount Debited
4. Amount Credited
WHY USE A JOURNAL?
1. The journal shows all information about a transaction in one place and
also provides an explanation of the transaction.
2. The journal provides a chronological record of all the events in the life
of a business.
3. The use of a journal helps to prevent errors.
1.3 POSTING TO THE LEDGER
Posting is the process of transferring the records from the journal to the
ledger. A ledger constitutes a group of accounts.
CHART OF ACCOUNTS
A Chart of Accounts is a complete list of the ledger account titles
used by the business. It shows all the possible account titles that a business
may use in its day-to-day transactions.
NEED FOR A LEDGER
1. Items of similar nature are grouped together.
2. It is easier to locate the item if information about it is needed.
1.4 TRIAL BALANCE
A Trial Balance is a list of accounts with open balances in the general
ledger. It proves the equality of the debits and credits in the general ledger.
1.5 ADJUSTMENTS AND ADJUSTING ENTRIES
Adjusting Entries are journal entries that are made to reflect the proper
amount of revenue realized and expenses incurred during the period. It also
needed to show a fairly measure of the assets, liabilities, and owner’s equity.
THE WORKSHEET
A Worksheet is usually prepared at the end of the period, but
before adjusting entries are formally recorded in the accounting records. It
is not a formal “step” in the accounting cycle. Rather, it is the “scratch
pad” upon which the accountants work out the details of the proposed end-
of-period adjustments. It also provides a preview of how the financial
statements will look.
A worksheet serves several purposes. It allows accountants to see
the effects of the adjusting entries, without actually entering these
adjustments in the accounting records. This makes it relatively easy for
them to correct errors or make changes in estimated amounts. It also
enables accountants and management to preview the financial statements
before the final drafts are developed. Once the worksheet is complete, it
serves as the source for recording adjusting and closing entries in the
accounting records and also for preparing financial statements.
1.6 CLOSING ENTRIES
Closing Entries are journal entries prepared at the end of the accounting
period to close the nominal accounts and transfer their balances to the capital
account.
NOMINAL VS. REAL ACCOUNTS
Nominal accounts are temporary accounts. These are the revenue
and expense accounts. This type of account is closed at the end of the
accounting period.
Real accounts are balance sheet accounts. Their balances are
carried to the next accounting period.
1.7 POST-CLOSING TRIAL BALANCE
A Post-closing Trial Balance is prepared after all closing entries
have been made. It consists only of accounts for assets, liabilities, and
capital.
1.8. REVERSING ENTRIES
Reversing entries are journal entries done at the beginning of the
next accounting period to reverse certain adjusting entries done in the
previous accounting period.
2. SOME TIPS ON RECORD-KEEPING PROCEDURES
2.1 LOCATING ERRORS
The trial balance should always be in balance. However, every student
soon discovers in working problems that errors are easily made which prevent
from trial balances from balancing. The lack of balance may be the result of
single error or a combination of several errors. An error may have been made in
adding the trial balance columns or in copying the balances from the ledger
accounts. If the preparation of the trial balance has been accurate, then the error
may lie in the accounting records, either in the journal or in the ledger accounts.
What is the most efficient approach to locating error or errors? There is no single
technique which will give the best results every time, but the following
procedures, done in sequence, will often save considerable time and effort in
locating errors.
1. Prove addition of the trial balance columns by adding these columns in the
opposite direction from that previously followed.
2. If the error does not lie in the addition, next determine exact amount by which
schedule is out of balance. The amount of the discrepancy is often a clue to
the source of the error. If the discrepancy is divisible by 9, this suggests either
a transposition error or a slide. For example, assume that the Cash account
has a balance of Php2,175, but in copying the balance into the trial balance,
the figures are transposed and written as Php2,157. The resulting error is
Php18, and like all transposition errors is divisible by 9. Another common
error is the slide, or incorrect placement of a decimal point, as when
Php2,175.00 is copied as Php21.75. The resulting discrepancy in the trial
balance will also be an amount divisible by 9.
To illustrate another method of using the amount of a discrepancy as a
clue to locating error, assume that the asset account Office Supplies has a
debit balance of PhpP420, but that is erroneously listed in the credit column of
the trial balance. This will cause a discrepancy of two times Php420, or
Php840, in the trial balance totals. Such errors as recording debit in a credit
column are not uncommon. Thus, after determining the difference in the trial
balance totals, you should scan the columns for an amount equal to one-half of
the discrepancy. Also scan the journal for an amount equal to the discrepancy.
Perhaps the amount has not been posted.
3. Compare the amounts in the trial balance with the balances in the ledger.
Make sure that each ledger account balance has been included in the correct
column of the trial balance.
4. Re-compute the balance of each ledger account.
5. Trace all postings from the journal to the ledger account. As this is done, place
a check mark in the journal and in the ledger after each figure are verified.
When the operation is completed, look through the journal and the ledger for
unchecked amounts. In tracing postings, be alert not only for errors in the
amount but also for debits entered as credits, or vice versa.
2.2 ADDITIONAL GUIDELINES
Currency signs (such as Php or $) are not used in journals or ledgers.
Some accountants use currency signs in trial balances; others do not. Currency
signs should always be used in the balance sheet, the income statement, and other
formal financial reports. In published financial statements of large corporations,
the use of currency signs is often limited to the first and last figures in a column.
When peso amounts are being entered in the columnar paper used in
journals and ledgers, commas and decimal points are not needed. On unruled
paper, commas and decimal points should be used. In case of even amounts (no
centavo amounts), cents column can be left blank, or if desired, zeros or dashes
may be used. A dollar or peso amount that represents a final total within a
schedule is underlined by a double rule.
3. ADJUSTING THE ACCOUNTS
Accounting information is vital to the decision makers and therefore it has
to be timely and relevant if it is to be useful to the management. Financial
statements are prepared on a time period commonly known as accounting period.
Most business enterprises use the one-year period as their primary accounting
period. A calendar year means that the accounting period begins on January 1
and ends on December 31. A fiscal year begins in any month and ends a year
after.
3.1 WHY THE NEED FOR ADJUSTMENT?
Before financial statements are prepared, several accounts need to be
updated or adjusted at the end of the accounting period so as to bring the correct
balances of the assets, liabilities, capital, income and expenses. This is to
conform to two accounting principles, namely: revenue recognition principle and
matching principle. Adjusting entries are needed at the end of each accounting
period to make certain that appropriate amounts of revenue and expense are
reported in the company’s income statement.
3.2 PRINCIPLES FOR ADJUSTMENTS
1. Revenue recognition principle
This principle states that revenue must be recognized when it is actually
earned, not before or after.
2. Matching principle
This principle requires that expenses be recognized as a result of earning
revenues.
These principles apply to the accrual basis of accounting. The objective of
accrual basis is to recognize revenue when they are earned not when cash is
received and recognize expenses when they are incurred not when cash is paid
out.
Example:
Items sold on credit. You recognize the sale for the whole amount even
cash is not yet received.
3.3 ACCOUNTS THAT NEED TO BE ADJUSTED
1. Provision for Depreciation
2. Provision for Bad debts
3. Accrued expenses
4. Accrued income
5. Prepaid expenses
6. Income collected in advance/Unearned revenues
DEPRECIATION
Fixed assets are those assets with useful lives extending beyond the
year when they were purchased. They are used by the business in its
operation and are not intended for sale. The value of these assets, except land
decreases as time passes by due to:
1. wear and tear from operations;
2. inadequacy and obsolescence
An asset is said to be inadequate for the business if there is business
expansion and the asset can no longer fulfill the needs of the business. It is
said to be obsolete in the introduction of new models or inventions and the
business desires to replace the old asset with a new one. The cost of the fixed
asset is allocated to the number of its useful life. Depreciation refers to the
cost of using the assets during their useful lives.
MAJOR FACTORS TO DETERMINE DEPRECIATION
1. Cost of the Asset
2. Estimated useful life of the asset.
3. Estimated salvage value or scrap value of the asset.
4. Date of Acquisition.
The most common and widely accepted method of determining
depreciation expense is the straight-line method. The formula is:
Cost of asset – salvage value
Estimated useful life in years = Depreciation expense per year
The journal entry is:
Depreciation expense, asset account xxx
Accumulated depreciation, asset account xxx
Depreciation is an expense account. Accumulated depreciation is a contra
asset account. A contra asset account is a balance sheet account which is
deducted from a related asset to show the proper amount of such asset. The asset
account is not credited to preserve the historical cost of the asset.
BALANCE SHEET PRESENTATION
Fixed Assets:
Service van Php175,000
Less: Accumulated depreciation 34,000
-------------
Net book value of the asset Php141,000
BAD DEBTS
Usually most business firms extend credits to attract more to sell
more goods. However, not all credits are good or collectible. For a reason
or another, a certain percentage of these collectibles are not collected.
Therefore a business should provide for such losses for non-collection of
credits. This loss is called bad debts. The entry to bad debts is:
Bad Debts expense xxx
Allowance for Bad Debts xxx
Bad debts expense is a nominal account which must be shown in
the income statement. Allowance for bad debts is a contra asset account
and is shown in the balance sheet as a deduction to accounts receivable.
BALANCE SHEET PRESENTATION
Current Assets:
Accounts receivable Php50,000
Less: Allowance for bad debts 500
-----------
Net realizable value Php49,500
METHODS OF COMPUTING FOR BAD DEBTS
1. As a percentage of accounts receivable
2. As a percentage of sales.
ACCRUED EXPENSES
These are expenses already incurred but not yet paid. This is
recorded as a liability account. Expenses that usually fall under this
category are:
1. Salaries of employees
2. Professional fees to contractors
3. Meralco bills, PLDT bills, water bills
4. Income tax remittances, PhilHealth remittances, SSS/GSIS remittances
5. Interest expense
The entry to record accrued expense is:
Expense account xxx
Accrued expense xxx
ACCRUED INCOME
This refers to income already recorded but cash not yet received.
This is recorded as an asset account. The entry to record accrued income
is:
Accrued income xxx
Income account xxx
PREPAID EXPENSES
These are expenses paid in advance of its use. This is recorded as
an asset account and subsequently adjusted as expenses for the portion that
was used up. The adjusting entry for this account depends on the original
entries made when it was paid.
METHODS OF RECORDING PREPAID EXPENSES
1. Asset method
Under this method, the original entry made is debited to asset account.
The adjusting entry at the end of the accounting period is the
recognition of expense portion by debiting the expense account for the
increase in expense and a credit to the asset account for the decrease in
asset.
2. Expense method
Under this method, expense account is charged when payment was
made. The end of period adjustment is a debit to asset account for the
unused portion and a credit to the expense account.
UNEARNED REVENUES
Unearned revenues are cash received in advance for income still to
be earned or rendered in the future.
METHODS OF RECORDING UNEARNED REVENUES
1. Liability method
Under this method, a liability account is credited upon receipt of cash. The
adjusting entry at the end of the accounting period is to recognize income
by crediting the income account for the earned portion and debiting the
liability account.
2. Income method
Under this method, the original entry made when cash is received is a
credit to income. The adjusting entry is to credit the liability account for
the unearned portion and a debit to income account.
References:
Ascan, T.C. 2005. Syllabus in Management 111 (Principles of Accounting). J.D. Drilon Faculty Grant. UP
Los Banos, College, Laguna.
Meigs, R.F. et. al. 1996. Accounting : The Basis for Business Decisions. 10th edition. McGrawhill, Inc.
Meigs, R.F., W.B. Meigs., M.A. Meigs. 1995. Financial Accounting. 8th edition. McGrawhill. Inc.
