Using an Accounting Cycle Example
Sometimes the best way to understand a financial or mathematical process is to be given an example of that process in action. For the accounting cycle, it can be helpful to visualize specific examples in each of the different steps. A single accounting cycle example has been taken through each individual step below to help with this visualization and subsequent understanding.
Preparing the Books
Joe the Plumber runs a successful plumbing and pipe repair business. He also employs several capable people, including his accountant Bill. In our accounting cycle example, Joe comes to Bill and tells him that the company has purchased a new piece of equipment, a 600.00 industry-grade "snake" used to unclog drains. The company has also recently completed a sink installation for a customer at a price of 250.00. Bill promptly takes Joe's copies of the two transaction receipts, files them, and prepares to input the numbers into his books.
Debits and Credits
Bill does his accounting using double-entry bookkeeping, so his ledger has two columns: one for debits, and one for credits. He uses a temporary ledger to record all transactions each month, and will finalize the transactions and begin a new ledger account every 30 days. It's currently the last day of July, so Bill files both transactions in his ledger for that month. He enters the 600.00 "snake" under the debits column as a purchase, and marks under the credits column that 600.00 have been removed from the company's bank account. The 250.00 job is entered under credits, and marked in the debits column as customer payment.
Balancing the Books
Now Bill balances out his debits and credits for the month. Each side should have the same amount; that is, the 600.00 and the 250.00 should have both been added to one side and subtracted from the other. The credit column is for all activity that results in income, white the debit column records purchases. If Bill has run his figures correctly, both sides of his ledger will cancel each other out, resulting in a balance sum of zero. This is how he knows he has run the figures correctly; otherwise, he will need to go back and correct any mistakes made during calculations.
Recalculation and Adjusted Entries
If the transactions add up, Bill can add them to a balance ledger recording all transactions for the month of July. This is called recalculation, as he will be recalculating the total debits and credits for the month to include the day's transactions. Companies that go through thousands of transactions every day, like grocery stores, have very long and complicated monthly balance ledgers. Bill must allow for adjusted entries - payments for transactions during July that have yet to be paid or received - but otherwise the calculations he makes are fairly simple.
Financial Statements and Closing Entries
Once Bill has tallied all of his recalculated transactions for the month of July, he will finalize them by drawing up a financial statement. This will be the formal record of Bill's calculations, and he makes notes on them to ensure that future readers will understand each transaction. In large companies and corporations, these notes are very important; for Bill, they are convenient but not crucial. He will then make his closing entries, which mark the statement as complete and ready to be filed away for tax records.
As you can see, Bill the accountant's job is a quite straightforward accounting cycle example. Often the jargon and confusing terminology of the accounting world can make bookkeeping seem like an overwhelming task, but this is rarely the case. You'll be balancing your own books before you know it!