The Accounting Cycle in Action

The Accounting Cycle

In the past articles, we discussed the process from analyzing of transactions as well as the journalizing of them to the preparing of the records for the next period's transactions. This is called the accounting cycle. There are ten steps in this process

  1. Transactions are analyzed and recorded in the journal.
  2. Transactions are posted in the ledger.
  3. The unadjusted trial balance is prepared.
  4. The adjustment data are assembled and analyzed.
  5. The end-of-period spreadsheet is prepared (this step is optional).
  6. Adjusting entries are journalized and posted to the ledger.
  7. The adjusted trial balance is prepared.
  8. The financial statements are prepared.
  9. Closing entries are journalized and posted to the ledger.
  10. The post-closing trial balance is prepared.

Now let's work through a hypothetical first month for Driden Enterprises.

The Accounting Cycle - An Example

In this section, we will illustrate the complete cycle for one period. In this case, we are operating with the period being one month. We will do this as the first month, in order to show how a company would begin. At the end, we will have the starting numbers for the second month. The same process would then be done for the next month, with the exception that the starting amounts would not be zero. Instead, they would be the ending amounts from this month.

The first thing we need is a chart of accounts. For this example, we will use the following as the chart of accounts:
Chart of Accounts

10 - Assets
11 - Cash
12 - Supplies
13 - Office Equipment
14 - Prepaid Rent
15 - Accounts Receivable
16 - Accumulated Depreciation
20 - Liabilities
21 - Accounts Payable
22 - Unearned Fees

30 - Capital Stock
31 - Fees Earned
32 - Dividend
35 - Rent Expenses
36 - Supply Expense
37 - Depreciation Expense
40 - Miscellaneous Expenses
50 - Income Summary
51 - Retained Earnings

Now we will go through each transaction, one at a time, to fill out the journal.

Step 1 - Transactions are analyzed and recorded in the journal

1. On March 1st, Barry decides that he is going to start Driden Enterprise. He puts in $50,000 in cash to the company. In exchange, he receives $50,000 of ownership, or stock, in the company.

Remember, for every action, there is an equal and opposite reaction. Therefore, for everything we get, we have to give. For everything we give, we have to get. What was the transaction that occurred? Barry "bought" $50,000 worth of ownership in the company. This we would represent as an increase to Assets, specifically cash. In addition, Equity is increased in the Capital Stock account. Since Cash is increased through a debit, and Stock is increased through a credit, we would prepare the journal entry as follows:

Remember the Accounting Equation. Assets must equal liabilities plus equity. In this case, we have an asset of 50,000 and we have an equity of 50,000, so we are in balance.

2. On the same day, Driden Enterprises purchased $500 in supplies and $1000 in office equipment. These are asset accounts. We will be increasing supplies and equipment with debits (since that is how we increase asset accounts). We will decrease cash with a credit, since that is how asset accounts are decreased. The journal would look like this:

These are all asset accounts. In our accounting equation, we have to keep the assets equal to liabilities and equity. Liabilities are still zero, and equity is still at $50,000.00. Where are we on the assets after this? We started with $50,000 in cash, lowered cash by $1,500, increased supplies by $500, and increased equipment by $1,000. Therefore assets are 50,000 - 1500 + 500 + 1,000, which equals $50,000. So even though we only handled items on the assets side of the equation, we are still in balance. Let's move on.

3. Also on the first, a building was rented to operate the business out of. Three months of rent was prepaid for this location in the amount of $3,000. The ledger would show as follows:

Again, both are assets, so we are still in balance with our accounting equation.

4. On March 5th, it was realized that more supplies would be needed to get through the month. At this point, another $12,000 in supplies were acquired. Driden Enterprises entered into an agreement with the supplier that these would not be paid at the time they were acquired, but rather would be paid at a later date. When journalizing these entries, supplies would be debited (increased). Since cash was not paid for them at the time they were purchased, cash would not be touched. The offsetting entry would be a credit to Accounts Payable, which is a liability. A credit to a liability increases the liability. Therefore, we're increasing an asset and a liability with these entries, keeping the equation in balance with $62,000 on each side. The journal entry would look like this:

5. On March 10th, work that had been performed for the month was recorded. At that point, there had been $1,000 of work done for customers who paid in cash. Fees Earned increases the Stockholder Equity, so this is represented by a credit. The journal entry would be as follows:

6. On March 10th, while recording the work that had been performed, there was more than just the work paid in cash. Other work had been done on account, similar to how the supplies were paid for on March 5th. The work was done with the agreement that the customers would pay for the work at a point in the future. The amount of this work was $25,000. This creates Accounts Receivable. The journal entry would be as follows:

7. On March 25th, $8,000 of the supplies that had been bought on account were paid for. This decreases cash by $8,000. This also decreases Accounts Payable by $8,000. This does not affect supplies, as there is no increase or decrease in supplies, just in the accounts paying for them. The journal entry would be as follows:

8. On March 26th, another $10,000 of work done on account is recorded. This is the same as step 6 above. The journal entry would be as follows:

9. On March 29th, some of the customers that work had been done for on account pay toward the amount owed. Driden Enterprises receives payments totaling $5,000. This does not affect fees earned, as there is no increase or decrease in the earnings, just in the accounts paying for them. The journal entry would be as follows:

10. On March 30th, Driden Enterprises pays a dividend to the stockholder in the amount of $10,000. This is a decrease to cash through a credit, and a decrease in equity through a debit to dividends. The journal entry would be as follows:

11. On March 30th, Driden Enterprises pays utilities in the amount of $800. The journal entry would be as follows:

Step 2 - Transactions are posted in the ledger

After all of these entries have been entered into the journal as above, they are then posted to the ledger. The ledger entries would look as follows:











Step 3 - The unadjusted trial balance is prepared

The next step is to take the ledger entries and prepare the unadjusted trial balance. This shows the totals in each account within the ledger. The unadjusted trial balance would look as follows:


The totals in the debit and credit columns must equal, or there is an error somewhere. Note that just because they equal does not mean that all of the entries have been made, nor that the entries were necessarily made correctly. For example, when the money was paid on the Accounts Receivable it is possible to have reversed the debit and credit on the AR and Cash accounts. The columns would still balance, but would be incorrect.

Step 4 - The adjustment data are assembled and analyzed

Before the financial statements can be prepared, the accounts must be updated. The four types of expenses that normally require adjustments are prepaid expenses, unearned revenue, accrued revenue and accrued expenses. For Driden Enterprises, the following data has been acquired on March 31 for analysis of possible adjustments:

a. One third of the three months of prepaid rent has been used up, in the amount of $1,000. This is expressed as: Rent expired during March is $1,000.
b. Supplies on hand on March 31 is $300.
c. Depreciation of office equipment for March is $100.
d. Unearned fees on March 31 is $1,000. This means that customers have paid for $1,000 worth of work from Driden Enterprises that has not yet been performed (prepaid).

Step 5 - The end-of-period spreadsheet is prepared (this step is optional)

This is an optional step, but one that will help with future steps. In this step, a worksheet is prepared showing the unadjusted trial balance, the adjustments detailed in step four, what the adjusted totals are, which entries show on the Income Statement and which ones show on the Balance Sheet. Below is what the spreadsheet for Driden Enterprises would look like. We'll discuss the entries in the next few steps.

Step 6 - Adjusting entries are journalized and posted to the ledger

The adjustments that were identified in step four have to be added to the journal. The entries are journalized with an offsetting entry as an expense. (a) $1000 of the prepaid rent was used up. Since rent is a debit, the $1000 is entered as a credit. The offsetting debit is entered into Rent Expense. (b) Since there is only $300 of the $12,500 supplies, that means that $12,200 have been used in the course of business. This is represented by crediting supplies $12,200, and debiting $12,200 to Supplies Expense. (c) Office equipment is depreciated by $100. We don't actually touch the office equipment account, as it we are not taking money out of the equipment account. Instead of crediting the equipment account, we therefore credit a new account called Accumulated Depreciation. The offset for this is to debit Depreciation Expense. (d) Unearned fees of $1000 is entered as a credit to a new liability account of Unearned Fees. This is a liability account, because we owe the work we've received this money for. Since it is cash received, we debit Cash for the offsetting $1000 entry. The journal entries would appear as follows:

The adjusted ledger appears as follows:














Step 7 - The adjusted trial balance is prepared

Now that we've made these adjusting entries, we can make another trial balance. As with the previous unadjusted trial balances, the total of the debits must equal the total of the credits. The Adjusted Trial Balance is shown below:

If you compare this to the worksheet in step 5, you will see that it matches up. This is one reason why not skipping that optional step is important.

Step 8 - The financial statements are prepared

Now that we have all of the information together, we are ready to create our financial statements.

The first statement that we will prepare is the Income Statement. The Income Statement shows part of the information under Stockholder Equity - Fees earned (income) and Expenses. The Income Statement is shown below:

If you compare this to the worksheet in step 5, you will see that it matches up. This is one reason why not skipping that optional step is important.

Next is the Retained Earnings Statement. This starts with the retained earnings from the previous month (in this case $0.00). To that you add the Net Income (or loss) from the Income Statement and subtract the dividend.

The next statement is the Balance Sheet. This lists the Assets on the left, with the Liability and Stockholder Equity on the right.

You'll notice that the total on the Balance Sheet does not equal the total from the balance sheet section of the worksheet in step 5. The purpose of the balance sheet in that section is to show that the Net Income (or loss) is the same difference between the debit and credit columns as in the Income Statement.

Step 9 - Closing entries are journalized and posted to the ledger

Now that we have our financial statements put together, we can close the temporary accounts and get ready for the start of the next period. Remember from the previous article that closing is done in four steps. Debit each revenue account and credit Income Summary; Debit Income Summary and credit each expense account; Debit Income Summary and credit Retained Earnings by the amount needed to zero out the Income Summary; Debit Retained Earnings and credit Dividends. This will zero out the revenue, expense, and dividend accounts. The journal entries would appear as follows:

The adjusted ledger appears as follows:















Step 10 - The post-closing trial balance is prepared

Finally, the post-closing trial balance is prepared. This will set the beginning balances for the real accounts for the next period. From these totals, the transactions of the next period are added.

The period is now closed. To see the full journal and ledger, click here