The accounting cycle
The combined process of recording and reporting the accounting events of a business is called the accounting cycle. The series of steps that make up the accounting cycle starts with an event and ends with its presence in the financial statement.
The steps of the accounting cycle are as follows:
- Record transactions
- Adjust accounts
- Prepare statements
- Close temporary accounts
This is the process of making an entry in the journal to recognize an event that has occurred.
Accounts are adjusted to reflect the effects of accrual accounting. For example: if a business last payroll due date is after the accounting period closes, the business will need to accrue the salaries owed to the employees.
Once all entries and adjustments have been made. The financial statements are prepared. There are 4 main financial statements that should be prepared:
- The profit and loss statement
- The balance sheet statement
- The statement of cash flow
- Statement of changes in equity
Closing Temporary accounts
Temporary accounts are accounts that close into the retained earnings at the end of an accounting period.
In a previous lesson we talked about the profit and loss statement and how the profit and loss statement was related to the balance sheet. We saw the revenue and expense account was netted with the retained earnings account: This happens during the closing process. The effect of this is to zero out all revenue and expense account so a new accounting period starts with a fresh slate.
The accounts that are closed to the retained earnings account are:
These accounts start from zero at the beginning of each accounting period and do not carry over.
Why are profit and loss accounts closed?
Closing the profit and loss account is comparable to your personal annual wages you earn on the job*. You do not get a w2 at the end of the year with the cumulative income how much you have earned since you started working. That information will not be very useful to you. What will be more useful to you is if you received the w2 that stated your income for just that year.
*This is what the retained earnings account does for a business: It accumulates the amount it has earned less the amount it has spent or withdrawn
Also, you create your budget on an annual basis. We know how much we make on an annual basis and we budget our annual expense based on what we expect to make in any given year. Imagine the night mare you will have to face if you had to budget annual expenses based on your cumulative income. That will be more information than you need and a waste of time.
In the same way a business needs a fresh start each year in these three accounts:
- Revenue accounts
- Expense accounts
At the end of the accounting period, whatever balance is in the profit and loss and dividend account is netted with retained earnings. The retained accounts is a permanent account because it does not get closed. Most balance sheet account (with the exception of the dividend account) are permanent account. That means they never get closed into any other account.