The Accounting Cycle
The accounting cycle is started and completed within an accounting period, which is the time in which financial statements are prepared. Accounting periods vary but the most common is that of the annual period which can be either a calandar year beginning on January 1st and ending on December 31st or a fiscal year which sets the beginning of the accounting period to any date. So, a fiscal year that begins on 1st April would end 31st March of the following year.
Note: It is not obligatory to use a calandar year.
A primary accounting rule relating to the use of an accounting period is that of the ‘matching principle’ of accrual accounting. Accruals are for goods and services paid in arrears so are actually estimates made ahead of invoices actually being received. On receipt of the invoices an adjustment may need to be made to the final amount in order for the expense to to be matched to the accounting period in which the revenue paying for them is earned.
Prepayments occur when the company pays an invoice or makes a payment for more than one accounting period in advance so are matched to dates after the transaction has been recorded.
Note: The accounting cycle is different than the budget cycle in that the former focuses on historical events and ensures transactions are reported correctly to provide information for external users. The latter relates to future operating performance and planning for future transactions and used for internal management purposes.
Beginning the Cycle
The accounting cycle begins with all business transactions being recorded as entries in a general journal, a chronological record built in the date order in which the transactions occur along with:
- A short description,
- Debit amount
- Credit amount
- A reference number.
These journal entries are then posted (transferrered) to the nominal ledger (also known as a general ledger) which records transactions that are debited and credited on a constant basis. This is known as double-entry book-keeping and it requires that there must always be an offsetting debit and credit for all entries made into the nominal ledger and which is typically divided into five main categories:
- Assets; These are any resources that are owned by the business and produce value. Assets can include cash, inventory, property, equipment, trademarks, and patents. (Cash, Accounts Receivable, Inventory, Land, Equipment) = Debits Increase, Credits Decrease;
- Liabilities; These are current or future financial debts the business has to pay. Current liabilities can include things like employee salaries and taxes, and future liabilities can include things like bank loans, lines of credit, mortgages or leases. (Accounts Payable, Notes Payable, Interest Payable) = Debits Decrease, Credits Increase;
- Equity: This is the difference between the value of the assets and the liabilities of the business. If the business has more liabilities than assets, it can have negative equity. Equity can include things like common stock, stock options, or stocks, depending on if the company is privately or publicly owned by owners and/or shareholders.
- Revenue; This is the business’ income that is derived from the sales of its products and/or services. Revenue can include sales, interest, royalties, or any other fees the business collects from other individuals or businesses.
- Expenses: Expenses consist of money paid by the business in exchange for a product or service. Expenses can include rent, utilities, travel, and meals.Debits Increase, Credits Decrease = Capital
Accounting software often refers to the nominal ledger as the Chart of Accounts where the entries are sorted into individual sub-ledger accounts, assigned an account type and denoted by the number range in which the account sits. These sub ledgers represent the sequence on financial statements:
- Fixed Assets
- Current Assets
- Current Liabilities
- Long Term Liabilities
- Capital and Reserve;
- Direct Expenses
- Depreciation and Sundry
- Suspense Accounts: This is a general ledger account where transactions are temporarily recorded as sometimes it is not clear what it is for. So, until become clear, it can be placed here for the time being.
The Trial Balance
The purpose of the Trial Balance (an internal report compiled from the accounting records) is to provide a quick check that for every debit entry made, an equal credit has also been made. Each debit and credit should include the same date and identifying code so in case of error, it can be traced back to a journal and transaction source document.
When the trial balance is first run, it is called the unadjusted trial balance and each line only contains the ending balance. Usually the accounting software will automatically block all accounts that have a zero balance from appearing. The format of the initial trial balance report contains the following columns:
- Account number;
- Account name;
- Ending debit balance (if any);
- Ending credit balance (if any).
If the journals are error-free and posted properly (in other words double entry has been maintained throughout) then the total of the trial balance should be equal but what what it won’t do is identify a) where errors have been made and b) what those errore are.
If they don’t balance then it cold be because there are:
- Mistakes in transferring the balances to the trial balance;
- Errors in balancing an account;
- Wrong amounts posted in the ledger;
- Entries made in the wrong column, i.e. debit instead of credit or vice versa;
- Reversals of opening balances;
- Timing differences for accruals and pre-payments;
- Additional invoices for late payments;
- Postings that have been omitted.
Adjusting the Trial Balance
An adjusted trial balance is a listing of all the company accounts that will appear on the financial statements after the year-end adjusting journal entries and corrections have been made. Preparing an adjusted trial balance is the last step before the financial statements can be produced. One of the most common adjustment are those of the timing differences for accruals and pre-payments.
Adjusted Trial Balance
The adjusted trial balance has two functions:
- To confirm that the total of the debit balances in all accounts equals the total of all credit balances in all accounts; and
- To be used to construct financial statements, specifically, the income statement and balance sheet.
Then comes the year end service charge financial statements.