The Accounting Cycle: From Source Documents and Journalizing to the Final Audit

The accounting cycle will vary according to each individual organization's needs, but we will try to generalize all the elements of the accounting cycle that should be found within a company's accounting practices. They include the following:

Source documents: As we learned earlier, source documents can be anything from a purchase requisition to an invoice or a receipt. These are the items that document that initiation of a financial transaction.

For example, an employee of the Orion Computer Repair Company calls Gateway Computers to get a quote on a computer. Gateway provides one or more product numbers and some price quotes, either by phone or fax. If the employee decides to purchase the computers from Gateway, she or he types up a purchase requisition that would describe the products and the price to pay for them.

Depending on the organization, this document is usually sent to a purchasing office, along with a budget on the purchase requisition. It is here that additional organizational checks and balances would be performed to make sure the requested purchase is legitimate. On approval, the employee would be issued a purchase order (PO) to give to Gateway. Gateway would ship the order and bill Orion by an invoice that matches up to the PO. Depending on the size of the organization, a purchase requisition may not even be needed; an employee might have the authority to create and send a PO directly, which would then match whatever invoice is sent so the company knows how to make the payment.

Journalizing: Basically, all the information generated from the source documents will be documented into the general journal (or a specific journal, depending on the volume of transactions). The journal is kept chronologically.

Posting: As we learned earlier, posting is the process of transferring journal entries to the general ledger or subsidiary ledgers, depending on the needs of a company, by account. The general ledger should be balanced, and you should run a trial balance report frequently to catch any errors during the process early on. Since most organizations use computer systems, this process of posting information from the journal to the ledger may be automated or require just a click of a button. The idea behind how it works is the same, though.

Balancing the Trial Balance: This process should be run frequently and is used to find balancing errors in the general ledger.

Balancing the worksheet: This process involves a worksheet that the accountant creates at the end of the accounting period. It needs to be created and balanced before any adjusting entries are journalized.

Adjusting entries: This process occurs at the end of an accounting period, and any financial transactions needing adjustments would need a journal entry that is then posted to the general ledger, just as any normal financial transaction is journalized and posted.

Closing entries: Basically, you want to clean up all of those open accounts related to revenue, expenses, interests, taxes, and what-have-you for the accounting period, so you can start anew on for the next period, typically a year. The result of closing all these transactions is to put a number in the retained earnings account, which reflects net income for the accounting period.

Financial statements: By this point, everything is posted, balanced, tested, adjusted, and all outstanding accounts are closed, so now you are ready to run your financial statements. In a computerized operation, this is done with a click of a button because everything else should be in place. There is not much to this procedure except copying amounts accumulated in the general ledger into the report format that your company uses.

Audit: It is good practice, and in many organizations required, to have an external party, such as a certified public accountant, review your findings to be sure that there are no serious errors or questionable practices and that everything is done in accordance with Generally Accepted Accounting Principles.

Here is an illustration of the accounting process to better help you visualize how it all works together:

The Accounting Period, Accounting Cycle, and Computerized Accounting Software

An accounting period is determined based upon an individual or business entity's annual schedule for reporting and filing taxes.

While some may opt for the accounting period to directly coincide with the calendar year, others prefer to stagger accounting periods so that they do not conflict with major holidays and other lifestyle factors.
Balancing the Books

Based upon the system of debits and credits known as double-entry accounting, accountants use a general ledger to track money as it flows in and out of a business. Via use of a balance sheet, they regularly log financial transactions that, over time, serve to present a snapshot of a business's financial health and prognosticate its longevity.

It is the goal of accountants to ensure all logged financial transactions adhere to the balance sheet equation:

Assets = Liabilities + Shareholders' Equity (Capital)

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Accounting Cycle

Commonly facilitated on a set schedule of monthly, quarterly, and annual periods, the act of preparing and submitting financial documents follows what is known as the accounting cycle. Thus, at regular intervals, this process entails a series of steps repeated each and every reporting period.

From start to finish, the accounting cycle encompasses the following series of steps:

During the Accounting Process

Identification of the transaction: This is accomplished using an original source document, such as an invoice, receipt, cancelled check, deposit slip, and/or purchase order that offers such vital information as amounts, dates, descriptions, and names and address of other parties.

Analysis of the transaction: Process by which accounts are assessed to determine changes in status, such as increases or decreases, as well as the specific amounts that were affected.

Inputting of journal entries: Activity by which transactions are recorded in the journal as both a credit and a debit for the purpose of achieving a balanced ledger. Journals, which are maintained in chronological order, may include such items as sales journals, purchase journals, cash receipts, disbursement journals, and/or the general journal.

Postings to the general ledger: At this time, journal entries are transferred over into general ledger accounts. General ledgers are maintained according to specific accounts. This inventory is included within the company's chart of accounts. Ledger accounts may be in the form of T-accounts (more detailed information about these will be presented in a subsequent chapter) or with the addition of balances.

Following the Accounting Process

Decipher trial balance: This is the calculation step taken to verify that the sum of the debits equals the sum of the credits. At this point, if the two do not match up, there exists an imbalance that needs to be detected and resolved. Even if the sum of the debits and credits is the same, a problem may still exist; but at least the two columns are balanced.

Adjustment of entries: This refers to time spent preparing and posting accruals and deferred items to journals and ledger T-accounts.

Adjustment of trial balance: This step provides assurance that after the end-of-period adjustments, debits still equal credits.

Preparation of financial statements: Within the process of creating financial statements, the following steps are taken: preparation of income statement, balance sheet, statement of retained earnings, and statement of cash flow liquidity. Such documents and information may be produced more often that at designated reporting intervals, as when needed to reflect applicable adjustments.

Importance of Financial Statements

At the end of a period, regardless of whether annually or several times per year, the purpose of accountants creating financial statements is to present an accurate depiction of the financial health or decline of a business.

Individuals as well as corporate structures rely upon the information contained within financial statements to move forward with business decisions, align with or separate from select companies, or make changes to existing protocols.

Business executives not only use financial reports to chart the course of their companies, project revenues and expenses, monitor cash flow, and plan for the future, but also for a host of reasons integral to the success or failure of their companies. Further, both current and prospective employees can use these documents to keep tabs on their employers' financial performance.

Financial statements also are reviewed regularly by stockholders and investors for the purpose of tracking a company's performance and comparing it with their competitors' standings. Essentially, they form decisions about investing upon such knowledge, while bankers use it to make decisions about lending.

Annual financial statements also are integral in supporting accountants' efforts to prepare and submit tax returns to the Internal Revenue Service. Additionally, on a day-to-day basis, accountants use financial reports as a means of tracking and recording the daily intake and outtake of cash flow.

Closing entries: Such figures need to be calculated and posted so that balances from temporary accounts can be transferred to a permanent holding site on the balance sheet. Examples of closing entries include revenues and expenses that are moved from the income statement to the owner's equity column on the balance sheet.

After-closing trial balance: Taken after the closing entries are all inputted, this, the final closing balance, is necessary in order to ensure the debits still equal the credits.

Accounting Cycles and Computerized Accounting Systems

As they move away from manually entering data into a handwritten, bound ledger toward utilizing a computer accounting system to facilitate most of the accounting process, companies and individuals have come to fully appreciate the time and energy saved, as well as the sizable number of errors reduced.

As a means for substantiating decisions made by management, as well as cultivating open and honest relationships with shareholders and other external audiences, companies heavily rely upon the accuracy and reliability of accounting figures.

In light of this, it is imperative that financial data is current, based upon real-time environments; accurate to the highest possible degree; and verifiable in light of other data and dates of entry.

Within manual-input systems, the aforementioned trial balances are needed; but in the case of computerized systems, tests to confirm the equality of debits and credits are not needed, as "the assurance of balance" consistently occurs as each amount is entered.

A benefit of using computerized systems, regardless of whether it is Quicken, QuickBooks, or AccountEdge, is that they are programmed to reject data that, upon entering, would cause an inequity between credits and debits. To the accounting entry person, such a red flag would indicate data that was inaccurate.

Another benefit of such software programs is that they are able, on a continual basis, to update the existing balance based upon the addition of new entries. This helps to greatly diminish the possibility of human error, thereby maintaining an almost unquestionable balance.

Thanks to the use of computerized systems, additional time-saving activities include regular payout and collection activities whereby programs have the wherewithal to make automatic adjustments at the end of each period; progressive preparation and production of financial statements immediately following the verification of account balances; and the generation of a closing process at the tail end of the each period.