Accounting Cycle: A Quick Guide

Steps in the Accounting Cycle (Ballada (2020), Financial Accounting and Reporting):

Before the end of the accounting period

1. Identification of events to be recorded
2. Transactions are recorded in the journal
3. Journal entries are posted to ledger

At the end of the accounting period

4. Preparation of a trial balance (unadjusted)
5. Preparation of the worksheet including adjusting entries
6. Preparation of the financial statements
7. Adjusting entries are journalized and posted
8. Closing entries are journalized and posted
9. Preparation of a post-closing trial balance

After the end of the accounting period

10. Reversing journal entries are journalized and posted

Step 1: Identification of events to be recorded

1. Identify the transaction from source documents
 A transaction is an agreement between a buyer and a seller to exchange goods,
services or financial instruments.
 In accounting, the events that affect the finances of a business must be recorded on the
books, and an accounting transaction will be recorded differently if the company uses
accrual accounting rather than cash accounting.
 Accrual accounting records transactions when revenues or expenses are earned or
incurred, while cash accounting records transactions when the business actually spends
or receives money. It may require a letter of intent or memorandum of understanding.
 A source document is the original document that contains the details of a business
transaction. A source document captures the key information about a transaction, such
as the names of the parties involved, amounts paid (if any), the date, and the substance
of the transaction.
 Take note that those transactions affecting the elements of financial statements (assets,
liabilities, equity, income and expenses) will be analyzed and are to be recorded in the
accounting books of the entity.

2. Indicate the accounts (assets, liabilities, equity, income or expenses) affected by the
transaction
 Elements of financial statements
According to financial position:
o Assets
 An asset is a present economic resource controlled by the entity as a
result of past events. An economic resource is a right that has the
potential to produce economic benefits.
 It is classified as either
 current (cash and other assets a company expects to convert into
cash, sell, or consume either in one year or in the operating cycle,
whichever is longer), or
 noncurrent asset (assets that cannot be converted to cash within
one year after the statement of financial position date).
 Typical examples: Cash, Investments, Trade and Other Receivables,
Inventories, Prepaid expenses, Property, Plant and Equipment, Intangible
Assets, Other assets, etc.
o Liabilities
 A liability is a present obligation of the entity to transfer an economic
resource as a result of past events.
 
Same as assets, it is also classified as
 current (company's short-term financial obligations that are due
within one year or within a normal operating cycle), or
 noncurrent liabilities (those obligations not due for settlement
within one year).
 Typical examples: Trade and other Payables, Bond payables, Mortgage
payables
o Equity
 Residual interest in the assets of the entity after deducting all of its
liabilities. Also called "net assets" of the entity.
 Holders of instruments classified as equity are known as owners.
 Terms used in reporting the equity differ according to the form of its
business.
 Equity is composed of the following:
 Capital (investment of the owner in the business; transfer of
resources from the owner to the business; adds to the equity of the
business)
 Drawings/Withdrawals (withdrawal of the owner for personal use;
transfer of resources from the business to the owner; reduces the
equity of the business)
 Income*
 Expenses*

The company’s financial position is used in analyzing the entity’s liquidity, solvency and
the need of the entity for additional financing. The basic accounting equation formulated
is:
“ASSETS = LIABILITIES + EQUITY”

According to financial performance:

o Income*
 Items that increase assets/decrease liabilities resulting to increase in
equity, other than contributions/investment by owners.
 Typical examples: Service Revenues, Sales (for merchandise
businesses), Gains and other income
o Expenses*
 Items that increase liabilities/decrease assets resulting to decrease in
equity, other than distributions/withdrawal by owners.
 Typical examples: Cost of sales (for merchandising businesses,
sometimes called Cost of Goods Sold), Selling and Distribution expenses
(marketing, advertising, delivery expenses, etc.), General and
Administrative expenses (mostly related to administrative function such as
office salaries, accounting and legal expenses, etc.), Other expenses and
losses

Financial performance pertains to the company’s operations and is used to analyze the
entity’s profitability. Profit or loss is calculated by this formula:
“PROFIT (+)/LOSS (-) = INCOME – EXPENSES”

 In most businesses, they have the listing of names of the accounts that a company has
identified and made available for recording transactions in its general ledger called
chart of accounts. It is also flexible, may be subject to change (such as adding
accounts) for better recording and summarizing the transactions.

Example:

Assets (1000)
 Account Title
#
1001 Cash and Cash Equivalents
1002 Accounts receivable
1003 Allowance for Uncollectible Accounts
1004 Inventory
1005 Prepaid expenses
1006 Land
1007 Building
1008 Accumulated Depreciation - Building

Liabilities (2000)
Account Title
#
2001 Accounts payable
2002 Utilities payable
2003 Mortgage payable

Equity (3000)
Account Title
#
3001 Owner - Capital
3002 Owner - Drawings

Income (4000)
Account Title
#
4001 Service income
4002 Other income

Expenses (5000)
5001 Salaries expense
5002 Utilities expense
5003 Advertising expense
5004 Rent expense
5005 Other expenses

 It is also considered that there are contra-accounts and adjunct accounts. These are
commonly seen in adjustments.
o Contra-accounts are accounts that reduces the value of the main accounts
recorded in the financial statements. Examples:
 Allowance for bad debts/uncollectible accounts (contra-asset account of
Accounts receivable to arrive at its net realizable value; the total amount in
which the company proved that it is uncollectible; for a particular period,
an expense account called uncollectible accounts expense is considered
to determine the total allowance to be reflected in the financial position)
 Accumulated Depreciation (contra-asset account of depreciable
properties; the accumulated amount of the depreciation expenses
recorded that decreases the book value of the depreciable properties due
to its age and its usefulness)
o Adjunct-accounts are accounts that increases the value of the main accounts
recorded in the financial statements. Examples:
 Premium on bonds payable (adjunct account of bonds payable that
increases its present value)

3. Ascertain whether each account is increased or decreased by the transaction

 In every transaction, there must be at least two (2) accounts affected. This is the duality
concept in accounting.
 Transaction analysis:
 o Source of assets – increase in assets, increase in liabilities or equity
 Example: Investing cash to the business. (Source of assets; increase of
cash-asset and capital-equity)
o Exchange of assets – increase in assets, decrease in other assets or vice versa
 Example: Purchase of equipment thru cash. (exchange of assets; increase
of equipment-asset but decrease of cash-asset)
o Use of assets – decrease in assets, decrease in liabilities or equity
 Example: Payment of liabilities. (Use of assets; decrease cash-asset and
decrease of liabilities)
o Exchange of claims – decrease in liabilities or equity, increase in equity or
liabilities
 Example: Received electricity bill for the current month. (Exchange of
claims; increase of utilities payable-liabilities but decrease equity in form of
utilities expense)
Analysis Effect on asset Effect on Effect on
liability equity
Source of Increase Increase in either liability or equity
assets
Exchange of Increase in one None None
assets asset account;
decrease in
another asset
account
Use of assets Decrease Decrease in either liability or
equity
Exchange of None Increase Decrease
claims Decrease Increase
Increase in one None
liability account;
decrease in
another liability
account
None Increase in one
equity account;
decrease in
another equity
account

 One tool in enhancing the transaction analysis is the use of a financial transaction
worksheet.

4. Determine whether the account is debited or credited

 The concept of “debit” and “credit” is based on Pacioli’s Double Entry Bookkeeping
System (the Venetian Model), where the duality concept must be considered.
 The terms debit (DR) and credit (CR) have Latin roots: debit comes from the word
debere, meaning "what is due," and credit comes from the word credere, meaning
"something entrusted to another or a loan."
 One tool in enhancing the transaction analysis involving debits and credits is the T-
account. This tool is used informally as a ledger in which transactions recorded are
posted.

Account title
Debit side (DR) Credit side (CR)

 In using the debits and credits, normal balances are to be considered. The normal
balance is the balance where the accounts are increasing. The normal balance of an
account is either debit or credit.
  Summary of the rule of normal balances as to the elements of the financial position:

Assets
*(DR) Increase (CR) Decrease
*normal balance

Liabilities
(DR) Decrease *(CR) Increase
*normal balance

Capital
(DR) Decrease *(CR) Increase
*normal balance

Drawings/Withdrawals
*(DR) Increase (CR) Decrease
*normal balance

Income
(DR) Decrease *(CR) Increase
*normal balance

Expenses
*(DR) Increase (CR) Decrease
*normal balance

Normal balances:
Assets/Withdrawals/Expenses (AWE) – Debit
Liabilities/Income/Capital (LIC) – Credit

Normal Balance Summary

(Debit) (Credit)
Assets Liabilities
Withdrawals Capital
Expenses Income

 In analyzing transactions, there must be at least one (1) account debited and at least
one (1) account credited.
 Also note that in analyzing transactions, the total debits must equal to total credits.

Step 2: Transactions are recorded in the journal

 An accounting journal is a book that contains chronological listing of a company’s transactions
and events. It documents the accounting transactions occurred and arranged based on the
transaction dates.
 The process of recording transactions in the accounting journal is called journalizing.
  It also records the transactions that were identified in the previous step in this format (This
pertains to a general journal):

Month Day Particulars P.R. Debit Credit

(DR) (CR)
MMM DD Account to be Debited XX P xxxxx
Account to be Credited XX P xxxxx
Caption (Notation/explanation)*
*For classroom purposes, the caption/notation may be omitted.

 The date of the transaction is based on the actual occurrence of the transaction as analyzed in
the previous step.
 The particulars column represents the accounts affected, together with the application of
transaction analysis and the rules of debit and credit, and the short explanation or notation
regarding the transaction occurred. It is noticed that the accounts to be credited should be
indented for determination of its balance (to distinguish whether debit or credit). Applying the
rules of debit and credit, the amount reflected in the account to be debited is shown on the left
side in the right portion of the journal, while the amount reflected in the account to be credited
is shown on the right side in the right portion of the journal.
 The posting reference (P.R.) is the reference number of the accounts used in recording
transactions which is located in the company’s chart of accounts.
 In the example entry, there is only one account debited and only one account credited. It is
called a simple journal entry. In case there are more than one account debited or more than
one account credited, it is called a compound journal entry.
 The general journal is the book of original entry, or the book of first entry.
 Some merchandising businesses prepare special journals to record specific types of high-
volume information that would otherwise be recorded in and overwhelm the general ledger. It
is to be discussed in the later topics.

Step 3: Journal entries are posted to ledger

 Transactions recorded in the general journal are then posted to the general ledger accounts.
 Posting means transferring the amounts from the journal to the appropriate accounts in the
ledger.
 The ledger is also called the book of final entry. It contains all the accounts (assets, liabilities,
equity, income and expenses) maintained in the business.
 Each account title in the chart of accounts has its own ledger.
 The ledger is arranged based on its accounts for preparation of financial statements, usually
the elements of financial position come first (assets, liabilities and equity, respectively), and
then the elements of financial performance (income and expenses, respectively).
 An informal way of posting is the application of T-account, which was discussed earlier.

 Examples of general ledgers:

Detailed sample:

Account Account Title Page #

#
Date Desc. J.R. Amount Date Desc. J.R. Amount
(DR) (CR)
MM/D1 xxxxx xx P xxx MM/ xxxxx xx P xxx
D3
MM/D2 xxxxx xxx xxx
Total P xxx Total P xxx
Balance (if total P xxx Balance (if P xxx
debits is higher total credits is
than total higher than
credits; the total debits;
difference the difference
between the between the
 total debits and total debits
total credits) and total
credits)

Using T-account (informal way)

Account title
MM/D1 P xxx MM/D3 P xxx
MM/D2 xxx
Total P xxx Total P xxx
Balance P xxx Balance P xxx
(if the total debits is higher than the (if the total credits is higher than
total credits; the difference total debits; the difference between
between the total debits and total the total debits and total credits)
credits)

 In accounting terms, footing is the adding up of the amounts in the same column (adding all
the debits and adding all the credits). To determine the final balance to be used in the next
steps, the difference between the total debits and total credits must be obtained, and the
higher absolute value between the debit and credit totals will be the basis as to its account
balance.

Step 4: Preparation of a trial balance (unadjusted)

 After posting the transactions to the ledger, a trial balance must be prepared to determine the
equality of debits and credits as recorded in the general ledger. Normally, the trial balance
prepared first is an unadjusted trial balance, since there are transactions that needs to be
adjusted, which is to be discussed in the later steps in the accounting cycle.
 The trial balance is the list of all accounts with their respective debit or credit balances and
prepared for verification of equality of debits and credits in the ledger at the end of each
accounting period or any time the postings are updated.
 Steps in preparing a trial balance:
o Indicate the heading (centered) the details of the trial balance (name of business, the
term “Trial Balance,” and the date)
o List the open accounts and their balances
o Total the debit and credit column
o Double-rule the totals of the debit and credit columns

 Example:

Source: https://www.principlesofaccounting.com/chapter-2/the-trial-balance/
  In case that the total debits and total credits are not equal, it means that the trial balance is
incorrect, therefore “not in balance.” Common errors are mathematical errors, incorrect
postings such as posting on the wrong side of the account or incomplete posting, and incorrect
transcription such as error in transferring the balance from the ledger.
 Some errors specifically mentioned in the book are transposition errors (an amount that should
be recorded as P2,300 was erroneously recorded as P3,200) and slide (misplacement of
decimal point; example is an error to record the balance of P1,000, in which was recorded
erroneously as P100 or P10,000).
 Tips in locating the error:
o If the difference between the two columns is either P1, P10, P100 or P1,000, it could
mean there is an error in addition or subtraction. As such, just re-add the trial balance
columns and recalculate the account balances.
o If the difference is divisible by 2, it could mean there is an error in posting on the wrong
side of the account. As such, you can scan the trial balance to check whether a balance
equal to half the difference has been posted on the wrong side.
o If the difference is divisible by 9, there is a transposition error. Likewise, if the difference
is divisible by 9 or 99, there is a slide error. Retracing the account balances on the trial
balance should be done to check whether there was an error in transferring the
balances from the ledger.
o If the difference is neither divisible by 2 nor 9, it could mean an omission of an account
balance from the trial balance was made. As such, scan the ledger, then the journal to
check whether a posting or journal entry has been omitted.
o If the trial balance is “not in balance,” it is suggested that the error be located first in the
trial balance, then to the ledger and then to the journal and business documents.
 It is said that the trial balance is “in balance” when the total debits equal total credits. Since the
trial balance proves the equality of debits and credits after posting, it does not guarantee
accuracy of journalizing and posting. Some errors existing even when the trial balance is “in
balance” are as follows:
o A transaction is completely omitted.
o Correct journal entry is not posted.
o A journal entry is posted more than once.
o Incorrect accounting titles are used in journalizing or posting.
o Offsetting errors made in recording the amount of transaction.

Step 5: Preparation of the worksheet including adjusting entries

 Adjusting entries
o Periodicity concept will be considered in this part, considering the reporting period in
which financial statements are to be prepared and presented to users.
o Accounting period may be:
 Calendar year – accounting period starting from January 1 to December 31 of the
same year; or
 Fiscal year – accounting period starting from date other than January 1 and ends
with date other than December 31 of the same year.
o Adjustments are to be made at the end of the accounting period for accruals and
deferrals, following the accrual basis of accounting when income is recorded when
earned while expense is recorded when incurred.
o Accruals pertain to:
 expenses that should be reported now, but have not yet been recorded or paid,
and
 revenues that should be reported now, but have not yet been recorded nor has
the money been received
o Deferrals occur when a company has:
 paid out money that should be reported as an expense in a later accounting
period, and/or
 received money that should be reported as revenue in a later accounting period
o In adjusting entries, there should be at least 1 income statement account and 1 balance
sheet account.
Summary on adjusting entries: (note that 1 and 2 are examples of accruals, while 3, 4, 5* and
6* are examples of deferrals; *special adjusting entries for deferrals)
Entry Made Should be Adjusting Entry
1. Accrued income (failure to
record the earned portion of
income)
Dr. Accrued income (asset- Dr. Accrued income (asset-
No entry made for accruals of earned) earned)
income Cr. Income (income-earned) Cr. Income (income-earned)

2. Accrued expense (failure to

record the incurred portion of
expense)
Dr. Expense (expense-expired) Dr. Expense (expense-expired)
No entry made for accruals of Cr. Accrued expense (liability- Cr. Accrued expense (liability-
expense expired) expired)

3. Prepayments (Advanced
payments for future expenses)

a. Asset Method (all payments

are considered as asset in full
at the time of payment)

Dr. Prepaid expense (asset) Dr. Prepaid expense (asset- Dr. Expense (expense-expired)
Cr. Cash (another asset) unexpired) Cr. Prepaid expense (asset-
Dr. Expense (expense-expired) expired)
Cr. Cash (another asset)

b. Expense Method (all

payments are considered as
expense in full at the time of
payment) Dr. Prepaid expense (asset-
unexpired) Dr. Prepaid expense (asset-
Dr. Expense (expense) unexpired)
Dr. Expense (expense-expired)
Cr. Cash (asset) Cr. Expense (expense-
Cr. Cash (another asset)
unexpired)
4. Deferrals (Advanced
collection for future income)

a. Liability Method (all

collections are considered as
liability in full at the time of
collection)
Dr. Cash (asset) Dr. Deferred/Unearned income
Dr. Cash (asset) Cr. Deferred/Unearned income (liability-earned)
Cr. Deferred/Unearned income (liability-unearned) Cr. Income (income-earned)
(liability) Cr. Income (income-earned)

b. Income method (all

collections are considered as
income in full at the time of Dr. Cash (asset) Dr. Income (income-unearned)
collection) Cr. Deferred/Unearned income Cr. Deferred/Unearned income
(liability-unearned) (liability-unearned)
Dr. Cash (asset) Cr. Income (income-earned)
Cr. Income (income)
5. Set up allowance for
doubtful accounts

No entry made Dr. Doubtful Accounts Expense Dr. Doubtful Accounts Expense
 (expense) (expense)
Cr. Allowance for Doubtful Cr. Allowance for Doubtful
Accounts (contra-asset – A/R) Accounts (contra-asset – A/R)

6. Set up depreciation

No entry made Dr. Depreciation Expense Dr. Depreciation Expense

(expense) (expense)
Cr. Accumulated Depreciation Cr. Accumulated Depreciation
(contra-asset – PPE) (contra-asset – PPE)

 Worksheet preparation (Ten-column worksheet)

o It serves as a guide in preparing financial statements. In this case, we are preparing a
ten-column worksheet.
o The first two columns represent the debits and credits of the unadjusted trial balance,
respectively.
o The next two columns represent the debits and credits of adjustments to be made,
respectively. Depending on the given account titles in the unadjusted trial balance,
additional account titles will be considered in the adjustment phase of worksheet
preparation.
o After the adjustments, the next two columns are the debits and credits of the adjusted
trial balance, respectively. Cross-footing will be made in preparing the adjusted trial
balance (getting the balances of the amounts in the same row (account title), applying
the rules of debit and credit).
o After the adjusted trial balance is the income statement column in which the income
statement accounts (income and expenses) or temporary/nominal accounts will be
shown as derived in the adjusted trial balance. Normally, the total debits and credits in
that column is not equal, and the difference is the company’s profit/loss. Note that the
business is operating at profit if the balance of the total credits in the income statement
column is greater than its total debits, otherwise it is operating at loss.
o After the income statement column is the balance sheet column. It shows the balances
of the balance sheet accounts (assets, liabilities, equity) or permanent/real accounts
derived from the adjusted trial balance, including the drawings account. Normally, the
totals of its debits and credits are not equal, and it will notice that the difference is the
same as the profit/loss in the income statement column. Rule: if total debits in the
balance sheet column is greater than its total credits, it is operating at profit, otherwise it
is operating at loss.

Step 6: Preparation of financial statements

 Financial statements are structured representation with the objective of providing information
about the financial position, financial performance and cash flows of an entity that is useful to a
wide range of users in making economic decisions.
 It is composed of the following:
o Statement of comprehensive income
 Income statement
 Other comprehensive income (to be discussed in higher accounting)
o Statement of changes in equity
o Statement of financial position (formerly known as balance sheet)
o Statement of cash flows
o Notes to financial statements
 Statement of comprehensive income (SCI)
o shows changes in equity during a period resulting from transactions and other events,
other than changes resulting from transactions with owners in their capacity as owners
(e.g. capital investment, drawings)
o includes statement of profit or loss (income statement) and other comprehensive
income
o income statement may be presented in two ways:
  Natural presentation/Single-step income statement – in which income and
expenses are classified according to its nature. For example, all salaries
expenses whether from marketing or administrative function will be combined in
one line item “salaries.”
 Functional presentation/Multi-step income statement – in which income and
expenses are classified according to function. Some functions are principally
related to the revenue-generating activities such as sale of merchandise or
rendering of services, selling or distribution, administrative and other general
expenses.

 Statement of changes in equity (SCE)

o A statement showing the changes and movements in the owner’s equity for the
accounting period.
o Equity increases when the owner invests during the accounting period and/or profits
were reflected in their operations. Equity decreases when there are withdrawals made
by the owner and/or losses were occurred in their operations.
o It depends on the forms of business organization as to the presentation.
 Sole proprietorship – owner’s equity
 Partnership – partners’ equity
 Corporation – shareholders’ equity
 Share capital
 Retained earnings (may be presented separately)
 Statement of financial position (SFP)
o It is a formal statement showing the three elements comprising financial position,
namely assets, liabilities and equity.
o It is also used in analyzing the entity's liquidity, solvency and the need of the entity for
additional financing.
o It is formerly known as "balance sheet."
o Format:
 As to assets (based on liquidity, from most liquid to least liquid; current asset
first, then noncurrent assets)
 As to liabilities (based on maturity, from short-term to long-term; current liabilities
first, then noncurrent liabilities)
 Lastly, the equity.
o Forms of SFP
 Report Form (three major sections in a downward sequence of assets, liabilities
and equity)
 Account Form (assets shown at the left side, liabilities and shareholders' equity
shown at the right side)
 Statement of Cash flows (SCF)
o Component of financial statements summarizing the operating, investing and financing
activity of an entity.
o It shows the detailed information on cash transactions for the particular accounting
period.
o Operating activities are those activities derived from the principal revenue-producing
activities of the business. (e.g. cash sales, cash purchases, cash paid for expenses for
the year)
o Investing activities are those activities derived from acquisition and disposal of long-
term assets (e.g. cash payment for equipment purchase, cash disposal of fully-used
machine)
o Financing activities are those activities derived from long-term funding and capital
investment of the business (e.g. owner’s cash investment his business, cash
withdrawals for personal use, cash receipt on issuance of long-term bonds)

Step 7: Adjusting entries are journalized and posted

 Refer to adjusting entries summary

Step 8: Closing entries are journalized and posted

  Closing entries are prepared to close all temporary/nominal accounts ultimately to the equity of
the business.
 Steps (in some cases, steps 1 and 2 may be interchanged, or may be combined as one step):
o Close all nominal accounts with credit balances to income summary account.

Income summary xxx

Nominal accounts (revenues, gains, etc.) xxx

o Close all nominal accounts with debit balances to income summary account.

Nominal accounts (expenses, losses, etc.) xxx

Income summary xxx

Note that the balance of income summary will be the same as to the balance shown in
the income statement column of the worksheet. Same rules apply.

o Close the income summary account to the capital account.

If profit (income summary after the previous steps has credit balance):

Income summary xxx

Owner-capital xxx

If loss (income summary after the previous steps has debit balance):

Owner-capital xxx
Income summary xxx

o Close the drawings account to the capital account.

Owner-capital xxx
Owner-Drawings xxx

Step 9: Preparation of a post-closing trial balance

 Post-closing trial balance is prepared after the closing entries are journalized and posted. It
has the same purpose as to trial balance discussed above.
 Only the permanent/real accounts will be shown in the post-closing trial balance [assets,
liabilities, equity (only the capital account)].

Step 10: Reversing journal entries are journalized and posted

 Reversing entries are entries to be made after the end of the current accounting period for the
simplicity of bookkeeping for the next accounting period.
 It reverses adjusting entries done pertaining to adjustments that increase either assets or
liabilities:
o Accruals of income or expense
o Deferrals of income using income method
o Deferrals of expense using expense method

~God bless~