Chapter 2
Overview of the Accounting Cycle
Definition
The accounting cycle is a multi-step process of recording, processing, and
reporting a company's financial transactions for a specific period.
The 9 Essential Steps
1. Analyze business transactions.
2. Journalize the transactions.
3. Post to ledger accounts.
4. Prepare a trial balance.
5. Journalize and post adjusting entries.
6. Prepare an adjusted trial balance.
7. Prepare financial statements.
8. Journalize and post closing entries.
9. Prepare a post-closing trial balance.
Step 1: Analyzing Transactions (Rules of Debit and Credit)
To record transactions, you must first determine how they affect specific accounts
using the double-entry system, where each transaction affects at least two
accounts.
Debit (Dr.)
An entry on the left side of an account.
Credit (Cr.)
An entry on the right side of an account.
The Rules of Increase/Decrease
◦ Assets: Increased by Debit; decreased by Credit.
◦ Liabilities: Decreased by Debit; increased by Credit.
◦ Owner’s Capital: Decreased by Debit; increased by Credit.
◦ Owner’s Drawing: Increased by Debit; decreased by Credit.
◦ Revenues: Increased by Credit (same effect as Capital).
◦ Expenses: Increased by Debit (opposite of Capital).
Normal Balance
The side of the account (debit or credit) that increases the account balance.
Step 2: The Recording Process (The Journal)
Definition
The journal is the "book of original entry" where transactions are recorded in
chronological order.
Types of Journals
◦ General Journal: A two-column form used for any business transaction.
◦ Special Journal: Designed for frequently occurring identical transactions like
sales or cash payments.
Components of an Entry
Every entry must include the date, the title of the account debited, the title of the
account credited (indented), the amounts, and a brief explanation.
Step 3: Classification (The Ledger and Posting)
The General Ledger
Contains the entire group of accounts maintained by a company.
Chart of Accounts
A "table of contents" for the ledger that lists account titles and their assigned
numbers in the order they appear in financial statements.
Posting
The process of transferring monetary amounts from the general journal to the
accounts in the ledger to group similar transactions together.
Subsidiary Ledgers
Used to show details for "controlling accounts" in the general ledger, such as
individual customer balances for Accounts Receivable.
Step 4 & 5: Adjusting Entries and Timing Issues
Periodicity Assumption
Accountants divide the economic life of a business into artificial time periods
(month, quarter, or year).
Purpose of Adjustments
Entries made at the end of a period to ensure account balances are accurate and
reflect revenues earned and expenses incurred before financial statements are
prepared.
Categories of Adjusting Entries
1. Deferrals (Prepayments): Adjusting items previously recorded as assets or
liabilities, such as Prepaid Expenses (e.g., insurance, rent, supplies) or Unearned
Revenues (cash received before service is performed).
2. Accruals: Recording items not yet received or paid, such as Accrued
Revenues (service performed but not yet billed) or Accrued Expenses (expenses
incurred but not yet paid, like salaries).
Depreciation
The process of converting the cost of an asset (like equipment) into an expense over
its useful life.
Steps 6 & 7: The Worksheet and Financial Statements
The Worksheet
A multiple-column working tool used to make it easier to prepare adjusting entries
and financial statements. It is not a permanent accounting record.
Worksheet Steps
1. Trial Balance -> 2. Adjustments -> 3. Adjusted Trial Balance -> 4. Extend to
Financial Statement columns -> 5. Compute Net Income or Loss.
Financial Statements
Prepared directly after the balances have been adjusted to reflect the company's
true position.