On other post of mine (Basic Accounting Cycle in 9 Steps), I briefly discuss the accounting cycle in nine steps, without example. Now, through this post, I explain the cycle with full case examples. Having this, hopefully you will get a better sense of taking the whole cycle steps, in the real accounting works.

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Although, in theory, the basic accounting equation can be used to prepare financial statements, virtually all firms would find that approach to be extremely cumbersome. Far more efficient processes are needed by firms that have hundreds of different assets and liabilities and engage in thousands of transactions.

The accounting process includes the steps summarized:

  • Identify transactions and events.
  • Analyze transactions and events in terms of the basic accounting equation.
  • Translate the transaction analysis into debits and credits.
  • Prepare journal entries and post to the general ledger.
  • Prepare and post adjusting entries.
  • Prepare the income statement.
  • Prepare and post closing entries.
  • Prepare the balance sheet.

But, before the case example, I would like to highlight some basic concepts you might have probably read, in brief or missed them altogether. Read on…

 

The General Ledger

The core of financial accounting is the analysis of transactions in terms of the basic accounting equation:

Assets = Liabilities + Shareholder’s Equity

[Info_Box]Note: Shareholder’s equity sometimes called as ‘capital’ or ‘Owner’s Equity’.[/Info_Box]

The purpose of this analysis is to summarize the effects of different types of transactions on the equation’s elements. In real business settings, this summarization is done in the general ledger.

Although most accounting systems are computerized, at this stage we will illustrate a manual system. In such a system, the general ledger often takes the form of a loose-leaf notebook. Each page is assigned to a particular equation item [such as cash, inventory, accounts payable, or invested capital] and is referred to as an account.

 

Debits and Credits (Again)

Recalling my previous post (Basic Accounting: Debit and Credit – Double Entry System). To show increases and decreases in account amounts, plus (+) and minus (–) signs could be used.

For several reasons, however, the accounting profession has discarded this alternative. Instead, each account is divided into a left-hand side and a right-hand side; increases are recorded on one side and decreases are recorded on the other.

For all accounts, the left-hand side is the debit side and the right-hand side is the credit side. If you perceive it to have no meanings other than left and right, respectively, this can be a source of confusion. While many non-accountants associate the term credit with something good, accountants must  came up with a better sense about this concept.

In actual business practice, general ledger accounts can take many forms. In educational world [and for simplicity], they are illustrated mostly using T-accounts. The side of an account in which increases and decreases are recorded depends on the nature of the account. Increases in assets are recorded by debits, and decreases are recorded by credits.

The rules for liabilities and shareholders’ equity are the reverse: increases are recorded as credits, and decreases are recorded as debits. The debit and credit rules, however, are largely arbitrary. Accordingly, with one exception, do not look for any special logic in them. One aspect of the rules does make sense, however.

Because assets appear on the opposite side of the basic accounting equation from liabilities and share holder’s equity, the debit and credit rules for assets are the opposite of the rules for liabilities and shareholders’ equity.

As an example, consider two illustrative transactions below:

  • First, shareholders invest $10,000 in a firm. In terms of the basic equation, this transaction increases cash and increases shareholder’s equity (invested capital): In the general ledger, an increase in cash is recorded as a debit, and an increase in shareholders’ equity is recorded as a credit.
  • The second transaction involves a purchase of inventory for $2,000. This transaction increases inventory and decreases cash: The decrease in cash is recorded as a credit, and the increase in inventory is recorded as a debit.

As previously mentioned, the rules for assets (which appear on the left side of the equation) are the opposite of the rules for liabilities and shareholder’s equity [which appear on the right side of the equation]. This is no coincidence. By reversing the rules, the equality of debits and credits for each transaction (and in total) is assured.

For example: when inventory is purchased for cash, inventory is debited and cash is credited for $2,000.

[Info_Box]The equality of debits and credits helps accountants identify and eliminate errors from the accounting process.[/Info_Box]

 

Balancing Accounts

To determine the net amount of cash, inventory, and so on at the end of an accounting period, the accounts must be balanced. This is done by totaling the debits and credits in each account and calculating their difference. This difference is shown on the side of the account that has the larger amount. These balances are the basis for the financial statements.

 

Chart of Accounts

Firms have a great deal of discretion in choosing their account titles and the number of accounts they employ. Accordingly, most firms develop a chart of accounts, which is essentially an index to the general ledger. It lists account titles and account numbers.

Account numbers are often employed because they provide a firm’s personnel with an efficient and unambiguous way to communicate.

 

The General Journal

In the general ledger, the information about a given transaction is spread across two or more accounts. This makes it difficult for auditors and others to review all the information about a given transaction.

The general journal is another major accounting record. It provides a chronological listing of all transactions and events. This enables the auditor to easily see all the accounts affected by a single transaction. As with the general ledger, the general journal in a manual system consists of a loose-leaf notebook.

 

Journal Entry [ies]

General journal entries are actually the first step in the formal financial accounting process. This step occurs after the accountant has conceptually analyzed the transaction in terms of the basic accounting equation, ascertained which accounts have increased or decreased, and translated the increases and decreases into debits and credits.

A transaction’s journal entry consists of:

  • the date,
  • the account(s) to be debited,
  • the account(s) to be credited,
  • the amounts, and
  • an explanation.

For example: if shareholders invest $10,000 in a firm on January 1, cash is increased and shareholder’s equity is increased. Translated into debits and credits, cash is debited and invested capital is credited. In journal entries, the debits are shown first, and the credits are indented and shown after the debits.

The journal entry for the $10,000 investment would be: Journal Entry: January 1

[Debit]. Cash = $10,000 [Credit].

Invested Capital = $10,000

[To record shareholder’s investment]

 

Posting

To determine account balances, the amounts in the journal entries need to be placed in the general ledger. Transcribing the amounts from journal entries into the general ledger is called “posting“.

From a procedural standpoint, transactions, events, and so on, are never initially entered into the general ledger. General journal entries are always prepared first and are then posted to the general ledger.

 

An Illustrative Accounting Procedures

Assume that Lie Dharma Putra Inc. began operations in January 2009 and engaged in a number of transactions. That example is used here to demonstrate the accounting procedures just discussed.

Transaction# 1. Shareholders invest $50,000.

Analysis: Increase cash; increase invested capital.

Debits and credits: Increase cash (an asset) by a debit; increase invested capital (an equity account) by a credit.

Journal entry: January 1

[Debit]. Cash = $50,000

[Credit]. Invested Capital = $50,000

[To record investment by shareholders]

Transaction#2. Lie Dharma Putra Inc. borrowed $20,000 from a bank.

Analysis: Increase cash; increase notes payable.

Debits and credits: Increase cash by a debit; increase notes payable by a credit.

Journal entry: January 1

[Debit]. Cash = $20,000

[Credit]. Notes Payable = $20,000

[To record note payable]

Transaction#3. Lie Dharma Putra Inc. paid in advance one year’s rent of $12,000.

Analysis: Increase prepaid rent; decrease cash.

Debits and credits: Increase prepaid rent by a debit; decrease cash by a credit.

Journal entry: January 1

[Debit]. Prepaid Rent = $12,000

[Credit]. Cash = $12,000

[To record prepayment of one year’s rent]

Transaction#4. Purchased inventory on account, $30,000.

Analysis: Increase inventory; increase accounts payable.

Debits and credits: Increase inventory by a debit; increase accounts payable by a credit.

Journal entry: January 1

[Debit]. Inventory = $30,000

[Credit]. Accounts Payable = $30,000

[To record the purchase of inventory on account]

Transaction#5. Purchased equipment for $25,000.

Analysis: Increase equipment; decrease cash.

Debits and credits: Increase equipment by a debit; decrease cash by a credit.

Journal entry: January 1

[Debit]. Equipment = $25,000

[Credit]. Cash = $25,000

[To record purchase of equipment for cash]

At this point, journal entries have been prepared for all of Lie Dharma Putra Inc. preliminary transactions. The next step is to post these entries to general ledger accounts.

 

Revenue and Expense Accounts

Revenue and expense transactions affect the retained earnings component of shareholder’s equity. For example: if a firm renders services in the amount of $100 to clients, on account, accounts receivable increases and retained earnings increases (see, again, the basic equation)

Assets = Liabilities + Shareholder’s Equity

Accounts Receivable: +$100

Retained earnings: +$100 [sales]

The income statement summarizes the many types of revenue and expense transactions that affect retained earnings during a period.

If all revenue and expense transactions were commingled in that one account, ascertaining the detailed amounts for each line item on the income statement would be quite difficult. Consequently, general ledger accounts are established for each revenue and expense item desired on the income statement.

Instead of initially debiting or crediting retained earnings for revenue and expense transactions, the revenue and expense accounts are used. These accounts are best viewed as temporary accounts, which are really components of retained earnings.

Increases in revenues are shown as credits, while increases in expenses are treated as debits. Note that expenses reduce retained earnings; so increasing the debit balance in an expense account actually decreases retained earnings.

The debit and credit rules for revenue and expense accounts are as follows:

Revenue:

Decreased: Record in Debit side

Increased: Record in Credit side

Expense:

Increased: Record in Debit side

Decreased: Record in Credit side

 

To illustrate Lie Dharma Putra Inc. revenue and expense transactions for January, 2009, assume that all transactions occur on January 15.

Transaction#6. Rendered services to customers for $200 plus a promised future payment of $400.

Analysis: Increase cash; increase accounts receivable; increase service revenue.

Debits and credits: Debit cash by $200; debit accounts receivable by $400; credit service revenue by $600.

Journal Entry: January 15

[Debit]. Cash = $200

[Debit]. Accounts Receivable = $400

[Credit]. Service Revenue = $600

[To record service revenue]

The preceding entry is referred to as a compound journal entry. Its distinguishing characteristic is that more than one account is either debited or credited [or both]. As with all journal entries, the total dollar amount of debits equals the total dollar amount of credits.

Transaction#7. Received $100 from customers for services to be performed at a later date.

Analysis: Increase cash; increase unearned revenue [remember that unearned revenue is a liability].

Debits and credits: Debit cash; credit unearned revenue.

Journal entry: January 15

[Debit]. Cash = $100

[Credit]. Unearned revenue = $100

[To record customers’ prepayment of revenue]

Transaction#8. Paid workers’ salaries of $700.

Analysis: Decrease cash; decrease retained earnings via salary expense.

Debits and credits: Credit cash; debit salary expense.

Journal entry: January 15

[Debit]. Salary Expense = $700

[Credit]. Cash = $700

[To record payment of salary expense]

Transaction#9. Received a $120 utility bill for services already used. Payment was not immediately made.

Analysis: Utilities expense increases; utilities payable increases.

Debits and Credits: Debit utilities expense; credit utilities payable.

Journal entry: January 15

[Debit]. Utilities Expense = $120

[Credit]. Utilities Payable = 120

[To record January utilities expense]

Transaction#10. Sold, for $4,000 on account, inventory costing $2,200.

Analysis: Accounts receivable increases; sales increases; inventory decreases; cost of goods sold (COGS) increases.

Debits and credits: Debit accounts receivable; credit sales; credit inventory; debit Cost Of Goods Sold [COGS].

Journal entry: January 15

[Debit]. Accounts Receivable = $4,000

[Credit]. Sales = $4,000

[To record a credit sale on account]

[Debit]. Cost Of Goods Sold = $2,200

[Credit]. Inventory = $2,200

[To record COGS on credit term of sale]

 

Adjusting Entries

Adjustments to the accounting records are typically needed before financial statements are prepared. The adjustments are needed to ensure that the account balances are correct and up to date. These adjustments result from interest accruals, depreciation, and a variety of other matters.

Adjustments to the account balances are accomplished by journal entries. We now analyze the adjustments needed to correctly state Lie Dharma Putra Inc’s accounts as of January 31.

Transaction#11. Incurred but did not pay interest expense of $133.

Analysis: Increase interest expense; increase interest payable.

Debits and credits: Debit interest expense; credit interest payable.

Journal entry: January 31

[Debit]. Interest Expense = $133

[Credit]. Interest Payable = $133

[To record January interest expense]

Transaction#12. Used $1,000 of prepaid rent.

Analysis: Increase rent expense; decrease prepaid rent.

Debits and credits: Debit rent expense; credit prepaid rent.

Journal entry: January 31

[Debit]. Rent Expense = $1,000

[Credit]. Prepaid Rent = $1,000

[To record January rent expense]

Transaction#13. Depreciation on equipment amounted to $208.

Analysis: Increase depreciation expense; decrease equipment by increasing the balance in the contra-asset account, accumulated depreciation.

Debits and credits: Debit depreciation expense; credit accumulated depreciation.

Journal entry: January 31

[Debit]. Depreciation Expense = $208

[Credit]. Accumulated Depreciation = $208

[To record January depreciation expense]

Transaction#14. Earned $50 of the $100 advance payment previously made by customers.

Analysis: Decrease unearned revenue; increase service revenue.

Debits and credits: Debit unearned revenue; credit service revenue.

Journal entry: January 31

[Debit]. Unearned Revenue = $50

[Credit]. Service Revenue = $50

[To record revenue earned]

The balances in the revenue and expense General ledger accounts should be correct now and the income statement.

 

Closing Entry [ies]

At this point, a problem exists in preparing Lie Dharma Putra Inc’s balance sheet.

Since the revenue and expense transactions, which really affect retained earnings, were not recorded in that account, the balance sheet will not balance. Therefore, the amounts in the revenue and expense accounts must be transferred to retained earnings. This is done via closing entries.

Let us say Lie Dharma Putra Inc’s closing entries at the end of January appear.

Viewed in isolation, closing entries do not make a great deal of sense. However, keep in mind their purpose: to transfer balances from revenue and expense accounts to retained earnings.

The balance now in retained earnings is that which would have been there if all the revenue and expense transactions were initially recorded in that account. Note that after posting the closing entries, the balance in each revenue and expense account is zero. This is why they are called temporary (or nominal) accounts.

Moreover, since the balances are zero, next month they will only reflect the revenue and expense amounts for February and not a cumulative amount beginning with January. This will enable the easy preparation of an income statement for the month of February.

 

Dividends

Lie Dharma Putra Inc. engaged in one more transaction in January. It declared and paid a $100 dividend to the shareholders.

The analyses are as follows:

Transaction#15. Paid dividend of $100.

Analysis: Cash decreases; retained earnings decreases.

Debits and credits: Debit retained earnings; credit cash.

Journal entry: January 31

[Debit]. Retained earnings = $100

[Credit]. Cash = $100 [To record dividend]

The posting of this entry is also reflected in the general ledger accounts.

At this point, all transactions have been journalized and posted, and the revenue and expense accounts have been closed to retained earnings. A balance sheet based on the account balances can be prepared.

Preparing general journal entries for each transaction is a laborious, time-consuming process; account titles must be written and often the same amount must be written twice in the same entry. Because of this, accountants have devised streamlined journalizing procedures that make use of special journals. Special journals are constructed to achieve great efficiency in journalizing transactions. Examples of special journals include sales journals, cash receipts journals, and cash payments journals.