Accounting Cycle

The Accounting Cycle—Discussion Guide

Slide #1 THINK ABOUT IT

The activities of many accountants are cyclical—their books are maintained across a specific amount of time and according to a repeated set of steps. When the steps are completed, and the books are “closed,” the accountant begins them again. These steps are collectively known as the accounting cycle.

KEY CONCEPTS

Slide #2 The accounting cycle is a six-step process that accountants use to collect, record, and report a business’s financial information.

• This cycle represents the basic bookkeeping and reporting actions that accountants complete on an ongoing basis.
  • The cycle begins at the opening of each accounting period and is completed at the end of an accounting period.
  • Once the final step in the accounting cycle is completed, the process begins again.
• An accounting period is an established amount of time during which financial information is collected and reported.
  • This time period can be set for any length of time. Some common accounting periods cover a single month, a quarter of a year, or an entire year, but these are not the only options.

Discussion #1: Ask students to discuss the respective pros and cons of selecting an accounting period that lasts a month, a quarter, or a year.

• The routinized activities of the accounting cycle aid accountants in the accurate recording and reporting of financial information.
  • The accuracy of this information is critical for the preparation of the financial reports during the later stages of the cycle.
  • Many people across multiple industries rely on the information in these reports to make business decisions.
• The first three steps in the accounting cycle relate to bookkeeping activities and must be performed on a daily basis to maintain a company’s journals and ledgers. These steps require the accountant to:
  • Analyze financial transactions.
  • Journalize business transactions.
  • Post journal entries to general ledger accounts.
• The remaining three steps involve processing the information recorded in the first three steps and summarizing this data into financial statements before “closing the books” for the accounting period. During these steps, accountants will:
  • Prepare a trial balance.
  • Prepare financial statements.
  • Prepare a post-closing trial balance.

Slide #3 Bookkeepers begin the accounting cycle by collecting source documents relating to the business’s financial transactions including checks, receipts, invoices, purchase orders, etc.

• Each financial transaction is analyzed to determine the total amount of the transaction and the accounts in the general ledger that will be impacted by the transaction.

Slide #4 Once the appropriate information is gathered from the source documents, the information from these transactions is recorded into journals in the order in which they occurred.

• Journals are considered to be the original point of entry for financial data.
• The information gathered in the first step of the accounting cycle will determine into which journal(s) to record the transaction.
• The date of the transaction, the amount to be debited and/or credited, and a brief description of the transaction is recorded into the journal(s).

Discussion #2: Ask students to consider why a description should be a part of the journal entry.

Slide #5 After the information has been recorded in the appropriate journal(s), it must also be recorded into the appropriate accounts in the general ledger.

• The general ledger is a collection of the accounts used to organize and store the information from a company’s business transactions.
  • It is considered to be the final point of entry for financial data.
  • The general ledger contains a separate section for accounts listed in the company’s chart of accounts.

Slide #6 Now that all of the bookkeeping activities have been completed, the accountant will prepare a trial balance.

• A trial balance is a worksheet that lists the different accounts found in a business’s general ledger along with their current balances at the end of an accounting period.
• The goal of a trial balance is to check to see if the total debits and credits match each other.
• If they do not match, steps are taken to locate the accounting errors that have occurred and make the necessary adjusting entries to correct them.

Slide #7 Next, accountants summarize the business’s financial information into reports that can easily be understood.

• They use accounting standards to ensure the financial information is consistent so that both internal and external users can accurately interpret the business’s financial statements, including:
  • Balance sheet
    • The balance sheet captures the business’s financial condition at a particular point in time. It presents the components of the basic accounting equation (Assets = Liabilities + Equity).
  • Income statement
    • The income statement, sometimes called the profit-and-loss statement, shows how much money the business has made or lost during a specific period of time, usually one year.
  • Cash flow statement
    • A cash flow statement is a financial summary that estimates how much money is expected to flow into and out of the business.
    • This information is used to plan ahead by generating more income and/or reducing expenses.

Slide #8 Finally, a post-closing trial balance is prepared to reflect a business’s adjusted financial information at the end of an accounting cycle.

• First, journal entries are prepared to reduce the balances of temporary accounts (such as revenue and expense accounts) to zero.
• Then, the balances of the temporary accounts are transferred to permanent accounts (such as asset, liability, and equity accounts).
• These entries, referred to as closing entries, are posted to the general ledger.
• After the closing entries are made, a post-closing trial balance is prepared.
  • At this point, the books are considered “closed” for the previous accounting cycle, and the process starts all over again.

Business Transactions—Discussion Guide

Slide #9 THINK ABOUT IT

The entire accounting cycle is founded on the need to accurately record and report the occurrence of business transactions. The term business transaction covers a wide range of activities and interactions; but no matter the form or type, each has an impact on a business’s financial condition. In many ways, business transactions are the reasons that businesses exist. From the largest multinational corporations to the smallest of companies, these exchanges are the fuel that keeps any business moving.

KEY CONCEPTS

Slide #10 A transaction is an event or activity involving the exchange of economic considerations such as a sale or purchase.

• A business transaction is a transaction that affects the financial conditions of an organization and whose details need to be entered into the organization’s accounting system.
  • A business transaction must be measureable in terms of money.
• For a transaction to be appropriately entered into an organization’s accounting system, each transaction must first be determined to be valid. A valid business transaction must:
  • Be measurable in money.
  • Affect the financial conditions of the business.
  • Relate to the business and be separate from the owner or manager of the business.
  • Be authorized by a designated person within the business.
  • Be evidenced by the existence of a source document.
• Each transaction can be categorized based on the form of the money exchanged (cash, credit, or non-cash) and whether the transaction involves more than one organization (external or internal).

Slide #11A cash transaction is a transaction in which a cash form of money is exchanged at the exact time of the transaction.

• In accounting, the term “cash” refers to more than just currency and coin.
  • Cash refers to a range of forms of financial exchange including currency and coin, checks, and debit card transactions.
• The money involved in a credit transaction is not exchanged immediately at the time of the transaction, but is agreed to be exchanged at a later date.
  • For example, many exchanges between businesses are handled through credit transactions in which one company provides a good or service and sends an invoice at a later date to request payment.
• Not all transactions that are paid by credit card are recorded as credit transactions, however.
  • If, for example, a person pays for a product with a credit card that has been issued by a bank (or other financial institution), the transaction is entered into the seller’s accounting system as a cash transaction.
  • This is because the individual making the purchase has technically entered into a credit transaction with the bank (the person will pay the bank at a later time), and the bank has entered into a cash transaction with the seller.
• A non-cash transaction is one that changes the financial conditions of an organization but does not affect the flow of money into or out of the organization.
  • An example of a non-cash transaction is depreciation in which the value of an asset decreases with time and use.

Discussion #1: Ask students to think of other examples of non-cash transactions.

Slide #12 An external transaction (sometimes called an exchange transaction) involves an exchange between an organization and an outside individual or organization.

• Typically, an external transaction involves the exchange of money for a good or service.
• An internal transaction (sometimes called a non-exchange transaction) is a transaction in which there is an event that is measureable in money and affects the financial conditions of the organization, but does not involve an outside individual or organization.
  • Payroll is a common internal transaction.
  • Depreciation is an example of a non-cash transaction that is also an internal transaction.

Discussion #2: Ask students to think of other examples of internal transactions.

Business Documentation—Discussion Guide

Slide #13 THINK ABOUT IT

Accountants and bookkeepers enter a lot of information into their journals and ledgers—so much, in fact, that mistakes are inevitable. Mistakes are an important reason why accountants keep a record of the sources of the information that they enter. If a mistake is uncovered in the books, sometimes the only way to double-check the error is to locate the document that was used to enter the information in the first place.

KEY CONCEPTS

Slide #14 Accountants don’t invent the numbers that they enter into a company’s financial records. Every entry that goes into the books has to come from somewhere. In almost all cases, that somewhere is a source document.

• Source documents are original, detailed records of completed transactions—they serve as evidence that the transactions occurred.
  • They can be physical documents (on paper) or digital documents, but they must be collected and stored as confirmation of a company’s financial information.
• Once the information has been recorded in the company’s accounting system, source documents are usually filed and stored for easy access in case someone needs to reference them at a later time.
  • In some cases, a source document is needed to verify that the financial data are accurate.
  • When a business’s financial records are reviewed by auditors, the source documents confirm that the records reflect actual transactions.
  • Source documents might also be referenced when verifying an amount due or when correcting an error in a journal or ledger entry.
• Typically, source documents contain the following information:
  • The date of the business transaction
  • The name of the businesses or individuals involved in the transaction
  • A description of the transaction
  • The amount of money exchanged
  • Some form of authorization (e.g., authorizing signature)

Slide #15 Depending on the nature of the business or industry, most accountants regularly encounter the same basic types of source documents.

• Some familiar examples of source documents include:
  • Bills
  • Receipts
  • Deposit slips
  • Checks
  • Pay stubs
  • Time cards

Discussion #1: Ask students if they can think of more examples of source documents that might contain information important for accountants.

• Some source documents that are less common outside of accounting are:

  • Cash memo—a “proof of purchase” document provided by a seller to a buyer that provides detailed information about a transaction for which a cash payment was completed

  • Invoice—a document provided to an organization or individual that provides detailed information about a transaction for which payment has not yet been completed

  • Purchase order—a legally binding document provided by a buyer to a seller that authorizes the seller to provide goods or services at an agreed-upon date, time, and price

The Accounting Equation—Discussion Guide

Slide #16 THINK ABOUT IT

The accounting equation is one of the most important and fundamental concepts in all of accounting. Without a full understanding of the basic accounting equation, double-entry accounting won’t make much sense.

KEY CONCEPTS

Slide #17 Before diving into the accounting equation itself, you need a thorough understanding of the basic parts of the equation. Some key definitions are:

• Assets are anything of value that a business owns.
  • These are resources that a business controls and can use.
  • A business’s assets can include a range of resources such as:
    • The cash in its bank accounts
    • Its inventory of products
    • The buildings or land it owns
    • The amount of monies owed to it for goods or services delivered but not yet paid for (accounts receivable)
• A liability is any amount (usually money) that a business owes.
  • Liabilities are obligations to pay money and typically include things like:
    • Salaries
    • Taxes
    • Debt
    • The amount of monies it owes for goods or services accepted but not yet paid for (accounts payable)
• Equity is the total amount of money invested in a business by its owners or shareholders.

Slide #18 The purpose of the accounting equation is to ensure that the period-ending totals on a business’s balance sheet are balanced (they equal each other).

• All that a company owns must equal everything that the company owes, including any investments made in the company by its owner(s) or shareholders.
• The basic formula for the accounting equation is:
  • Assets = Liabilities + Equity
• Because the accounting equation is always true, following this equation keeps everything in perfect balance.
• This formula is the foundation on which the entire double-entry accounting system is built.

Slide #19 Double-entry accounting is an accounting system in which every transaction is recorded as a separate entry into at least two accounts.

• The specific accounts that are impacted by a transaction are the ones into which an entry is made—there is no maximum number of accounts impacted by a transaction, but there will be at least two.
  • For example, if a company buys a computer on credit, this transaction will impact an account that records the company’s assets (they gained the asset of a computer) as well as an account that lists the company’s liabilities (since the company has not yet paid for the computer).
  • This transaction would then be recorded as an entry into each of these accounts.
• The entry of each transaction into multiple accounts is how the accounting equation is put into practice.
  • When taken together, the amounts entered into the accounts will always balance. In this case, the value of the computer (asset) equals the amount owed for the computer (liability).

Discussion #1: Ask students what it would mean if the accounting equation did not balance out. What would they do if they found that their assets did not match their listed liabilities?

Slide #20 How these transactions are entered into the separate accounts depends on the type of account that is impacted.

• An account is a distinct record of the total increases and decreases related to a specific asset, liability, equity, revenue, or expense.
  • An asset account charts the amount of a particular kind of asset that the business owns.
    • Common asset accounts include cash accounts, accounts receivable, inventory, and fixed assets.
  • A liability account charts the amount of a particular kind of liability that the business owes.
    • Common liability accounts include accounts payable, accrued liabilities, and wages payable.
  • An equity account charts the amount of investments from the owner(s) or shareholders, including retained earnings accounts.
  • A revenue account charts the amount of incoming money from a particular activity during the accounting period.
    • Common revenue accounts include sales revenue and product revenue.

• • An expense account charts the amount of outgoing money related to a particular activity during the accounting period.
    • Common expense accounts include utilities expense, rent expense, advertising expense, and cost of sales.
• Each business will determine the number and types of accounts that it needs based on a unique set of factors such as the type and size of the business.

Slide #21 Transactions are recorded into accounts as either debits or credits.

• Many people who do not work in accounting might consider a debit as a transaction that adds to a balance and a credit as a transaction that subtracts from a balance.
  • However, in accounting, the effects of these transactions are more complicated than that.
• A debit is an entry that increases the balance of an asset or expense account and decreases the balance of a liability, revenue, or equity account.
• A credit is an entry that decreases the balance of an asset or expense account and increases the balance of a liability, revenue, or equity account.
• The relationships of these entries to the respective accounts is crucial to successful double-entry accounting.
  • They might seem difficult to understand now, but, over time, these relationships will become second nature and using them appropriately will seem automatic.
• Here is a chart that combines the basic accounting equation with debit and credit relationships:

• For more information and examples of the accounting equation in action, click here for another great video from Accounting Stuff:
  • https://www.youtube.com/watch?v=56xscQ4viWE

Chart of Accounts—Discussion Guide

Slide #22 THINK ABOUT IT

In every accounting system, a detailed listing of a company’s accounts and account codes is crucial for maintaining and organizing the company’s financial records.

KEY CONCEPTS

Slide #23 A chart of accounts is a complete list of the accounts contained in a company’s general ledger and the codes assigned to them.

• General guidelines suggest that a company should maintain a chart of accounts that stays mostly consistent over a long period of time but is also flexible enough that accounts can be added or subtracted from the list as needed.

Discussion #1: Ask students to discuss why they think it would be important to have a chart of accounts that remains largely the same over multiple years. What might happen if the chart changes too often? What might happen if the chart never changes?

• When selecting the number, type, order, and coding of accounts, a number of factors should be considered, such as:
  • Type of business
  • Financial reporting requirements
  • Complexity of business structure
  • Level of detail needed
  • Accounting method (accrual vs. cash)
  • Accounting system (computer vs. manual)

Slide #24 In a chart of accounts, the accounts are typically listed by their account type.

• In the following order:

  • Asset Accounts

  • Liability Accounts

  • Equity Accounts

  • Revenue Accounts

  • Expense Accounts

• Within each account group, individual accounts are listed. For example, the company’s cash account is often listed first, followed by the other asset accounts.

  • This order is based on the financial statement in which the account balance is reported.

  • Asset, liability, and equity accounts appear on the company’s balance sheet and the remaining accounts are included on the company’s income statements.

  • The use of additional account types or the splitting of basic types into more specific ones is sometimes needed in larger or more complex business structures.

Slide #25 Each account in the chart is listed with a code that is specific to it.

• There are a number of ways that companies choose to structure these codes, but largely they are designed so that all asset accounts begin with the same number (usually 1), all liability accounts begin with the same number (usually 2), and so on down the line.
• Depending on the complexity of the coding system, each subsequent digit will further classify the account into increasingly specific subgroups.
  • For example, consider the following code breakdown of a company’s Internet Utilities Expense Account:
    • 54600 – Internet Utilities Expense Account
      • 5XXXX – Expense Accounts
      • 54XXX – Utilities Expense Accounts
      • 546XX – Internet Utilities Expense Accounts

Discussion #2: Ask students to discuss the importance of having a coding system. Why do they think each account needs a code? Would it matter if the accounts were just listed by their name?

• Whether the coding system is based on three, four, five or more digits, room should be left between account codes for the inclusion of additional accounts that might be needed at some point in the future.
  • For example, if the company needed to add a new account for the expenses related to Wi-Fi or 5G Internet services, there would be room to add “54610 – 5G Internet Utilities Expense Accounts” and still have the space to add another nine accounts before getting to code 54700.

Slide #26 While all chart of accounts will list account codes and title, each company can choose what additional information to include on its chart of accounts.

• Some charts of accounts include columns for:
  • Account type
  • Account description
  • How credits and debits impact the account balance
  • Which financial statement will reflect the account balance

Slide #27 Here is a sample chart of accounts.