The Accounting Cycle

Accountants work through a cycle called the Accounting Cycle.

A manager does not need to go into great depth in terms of understanding the accounting behind the financials; however, it does help to have a basic idea of where the numbers are coming from.

The accounting profession is made up of varying degrees of qualifications. You get accountants, chartered accountants, financial accountants, management accountants, auditors and bookkeepers.

The Accounting Cycle is illustrated:

Click here to view a video that explains the accounting cycle terminology.

Click here to view a video that explains the steps of the Accounting Cycle.

Let us work through each step of the cycle:-

Step One: Identify the Transaction

Identify the event as a transaction and generate the source document.

Transactions will include things like purchases, making a sale and issuing credit. Source documents are the documents that show proof of the transaction. Source documents include things like invoices, receipts, cheque counterfoils and credit notes.

Step Two: Analyze the Transaction

Determine the transaction amount, which accounts are affected and in which direction.

The transaction amount will be the amount in Rands of the purchase or sale etc. Accountants will then enter the transaction amount into the accounts. Accounts are opened for each element of a financial statement and all the transaction amounts that apply to that particular item are recorded in the relevant account. Accounts are divided into two symmetrical sections called debits and credits. The debit section is shown on the left-hand side and the credit section is shown on the right-hand side. The side on which the transaction is captured depends on whether the transaction increases or decreases the particular asset or liability or income or expense. For example, if there was an increase in the asset account, the entry would be recorded on the debit side of the account. If the asset had decreased, the entry would be recorded on the credit side of the account.

Which side of the accounts needs to be debited and which side of the accounts needs to be credited can often be confusing to the non-accountant. For the purposes of this course, it is not essential for you to grasp accounting concepts in detail, however, some examples of debits and credits are shown in the tables below:

Table Depicting Examples Of Debits And Credits For Expenses And Incomes:

Table Depicting Examples Of Debits And Credits For Assets And Liabilities:

Accountants follow what is called “The Double Entry Rule”. An accounting equation must always balance, so a transaction always affects two elements at the same time. One element will be debited, and one element will be credited.  

Let us look at a couple of very basic accounting examples:

Example 1 - On the 11^th of January 2009, wages were paid to an employee by the name of Andrew Smith in the amount of R500.

The wages account would be debited by R500 and the bank account would be credited by R500 at the same time, in line with the double-entry rule.

Example 2 - On the 12^th of January 2009, the organisation received an amount of R350 from a customer for services that were rendered.

The bank account would be debited by R350 and the services rendered account would be credited by R350 at the same time in line with the double-entry rule.

Step Three: Journal Entries

The transaction is recorded in the journal as a debit and a credit.

Once the accountant knows which accounts to debit and which accounts to credit, the records are made in the books of first entry or Journals. The examples used in Step two are shown as journal entries below:

Themba’s Clothing - General Journal for January 2009

Step Four: Post to Ledger

The journal entries are transferred to the appropriate T-accounts in the ledger.

The ledger is simply a summary of the transactions that were recorded in the journals. The example from Step two and Step three is shown in a simple ledger below. CPJ stands for “Cash Purchases Journal” and CRJ stands for “Cash Receipts Journal.”

 Dr. (+)                                   (Asset)          (Wages)                    1                      (Cr. (-)

Dr. (+)                                   (Expense)     (Bank)                       B1                   (Cr. (-)

Dr. (+)                       (Income)                  (Services Rendered)          I2        (Cr. (-)

Step Five: Trial Balance

A trial balance is calculated to verify that the sum of the debits is equal to some of the credits.

A trial balance is a list of all the balances of the accounts that were depicted in the general ledger. The trial balance can be used to confirm that the total of accounts with debit balances still equals the total of the accounts with credit balances. The example as carried over from Step four is shown below:

Themba’s Clothing - Trial balance as of 31 January 2009

Step Six: Adjusting Entries

Adjusting entries are made for accrued and deferred items. The entries are journalised and posted to the T-accounts in the ledger.

In accounting, adjustments are made at the end of the financial year to reflect any transactions that did not appear in the source documents. These adjustments are made for the sake of accuracy. Adjusting entries would need to be made in the journal and the ledger.

For example, let us say that wages were incorrectly entered at R500, and the correct amount was actually R450. Let us also assume that we owed R600 for the rent for the month but we paid R1 200 and this entry was not recorded. The adjustments would need to be reflected in the journal and ledger as follows:

Themba’s Clothing - General Journal for January 2009 

Dr. (+)           (Expense)                   (Wages)                    I1                      (Cr. (-)

Now we put the correct entry through:

Dr. (+)                                                                                                         (Cr. (-)

Then we record the entry that was not entered:

Dr.(+)                                                                                                      (Cr. (-)

Dr. (+)                       (Asset)          (Pre-paid Expense)  B2                     (Cr. (-)

Dr. (+)                       (Asset)               (Bank)                B1                              (Cr. (-)

 Dr. (+)                      (Asset)          (Rent Expense)                    I3                      (Cr. (-)

Step Seven: Adjusted Trial Balance

A new trial balance is calculated after making the adjusting entries.

Once the adjustments have been made, a new trial balance has to be drawn up. The example is depicted below:

Themba’s Clothing - Adjustment trial balance as of 31 January 2009

Step Eight: Financial Statements

The financial statements are prepared.

The financial statements are then prepared from the trial balance.