Understanding the accounting cycle and importance of accounting
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The Importance of Accounting
To understand accounting information and use accounting information is important for any business. "Information that is provided to external parties who have an interest in a company is sometimes referred to as financial accounting information," according to Williams, Haka, Bettner, and Carcello (2006, p. 4). The main reason in providing accounting and financial information is the use of said information in decision-making purposes. Many groups, including company management, government regulatory agencies, creditors, and suppliers, use financial information in various ways to determine a company's financial health and ability to meet obligations as such obligations become current. Companies and their personnel must understand the various steps in the accounting cycle and how such steps provide reliable information to the users of financial information.
What is the Accounting Cycle?
The accounting cycle is the "sequence of accounting procedures used to record, classify, and summarize accounting information in financial reports at regular intervals" (p. 94). The final preparation of formal financial statements is always started with the recording of business transactions and this cycle repeats so the business can prepare new, current, financial statements in response to business transactions conducted by the firm. The accounting cycle is composed of eight steps and includes journalizing transactions, posting journal entries to ledger accounts, preparing a trial balance, making end-of-the-period adjustments, preparing an adjusted trial balance, preparing financial statements, journalizing and posting closing entries, and preparing an after-closing trial balance.
Remember debits increase assets while credits increase owner equity during the recording and adjustment phases of the accounting cycle. An account "has only three elements: (1) a title; (2) a left side, which is called the debit side; and (3) a right side, which is called the credit side" (p. 95); such accountings are called T accounts because, on paper, the recording of such accounts resembles the letter "T." A sample T account is below:
The account balance is determined in the difference between the debit and credit sides of the account. If the debit total is more than the credit total, the account is said to have a debit balance. If the credit total is more, then the account is said to have a credit balance. In asset accounts, the debit recording increases the amount in the asset account and a credit decreases the amount in the account. Under liability and owners' equity accounts, the debit decreases the amount in the account, while a credit increases the amount in the account. This aligns with the equation
and is known as the system of double-entry account.
The first step involves placing the business transactions into a journal, which records the business transactions chronologically (day-by-day). The amounts entered in this section are transferred to the debit and credit sections of the accounts in the ledger. A person investing in the firm pays $80,000 in cash in exchange for stock in the firm. The two accounts affected by this transaction are the Cash and Capital Stock. The first step in journalizing this entry is entering the name of the account debited (Cash), which is written first, along with its dollar amount entered in the left-hand money column. The name of the account credited (Capital Stock) appears below Cash and is indented to the right, with the dollar amount appearing in the right-hand money column. A description of the transaction appears below the journal entry. Below is a sample journal entry:
Posting to Ledger Accounts
"Posting simple means updating the ledger accounts for the effects of the transactions recorded in the journal" (p. 98). If the person reads the journal entry aloud, this means the previous journal entries are read as "Debit Cash $80,000; credit Capital Stock, $80,000." A person copies the journal entry amounts into the general ledger, which is a series of T account entries; this is performed in the ledger as follows:
This process is continued until all journal entries are record in the ledger. Once all of the ledger entries are calculated, the next step is the preparation of the trial balance.
The trial balance is prepared to ensure debits and credits equal one another. All of the ledger accounts are listed, "with debits in the left column and credits in the right column" (Internet Center for Management and Business Administration, 2007). The debit column is added first, then the credit column. If the totals do not agree, the issue could be a debit was recorded instead of a credit, mistakes in arithmetic, and clerical errors in copying account balances into the trial balance. Both columns should be equal; however, this does not mean that a transaction was recorded in the wrong account. A sample trial balance is displayed below:
Making End-of-period Adjustments
Adjustments after the trial balance is created to record accrued, deferred, and estimated amounts and posting the adjusted entries to the ledger accounts. Once the entries are entered in the ledger, the accountant prepares the adjusted trial balance, which contains similar steps to the unadjusted trial balance; however, the adjusted trial balance contains the adjusting entries. Accrued items would include salaries, interest income, and unbilled revenue; deferred items would include prepaid insurance, office supplies, and depreciation.
Preparing Financial Statements
"Publicly owned companies-those with shares listed on a stock exchange-have obligations to release annual and quarterly information to their stockholders and to the public" (Williams, Haka, Bettner, and Carcello, 2006, p. 192). The financial statements include the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows (also known as the cash flow statement). The income statement is prepared first because it determines the amount of net income in the statement of retained earnings. The statement of retained earnings is prepared next to provide information for the balance sheet. The balance sheet is prepared from the assets, liabilities, and equity accounts of the firm. Finally, the cash flow statement is prepared using data from the other financial statements.
Preparing Closing Entries to Journals and Ledger Accounts
Closing journal entries closes temporary accounts such as revenues and moves these accounts to a temporary income summary account. The balance is then transferred to the retained earnings account, which is a capital account; likewise, dividend or withdrawal accounts are closed to capital. Closing entries are then posted to the ledger accounts. After these tasks the after-closing trail balance is created to ensure debits equal credits. Error-checking and correction is made to this trial balance.
The Importance of the Accounting Cycle Re-visited
All businesses prepare financial statements, so it is important all accountants understand the accounting cycle to ensure the proper entry of data and credible financial information out put. Eight steps comprise the accounting cycle, from the journalizing of business transactions to preparing after-closing trial balances. Without the accounting cycle, the information provided in financial statements would not be reliable and decision-making processes would be difficult to perform by users of financial information.
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