Principles of Financial Accounting: The Accounting Cycle - Steps in the Accounting, Cycle

What It Is

The accounting cycle is a series of steps that accountants follow to record, classify, and report financial transactions. It begins with the identification of transactions and ends with the preparation of financial statements. If a company buys $10,000 of inventory on credit, the accounting cycle will guide the accountant to record the transaction, update the accounts, and report the financial position and performance.

Key Concepts & Formulas

• Matching Principle: Matches costs with revenues in the same period. Example: If a company sells a product for $100, the cost of goods sold (COGS) should be matched with the revenue in the same period.
• GAAP (Generally Accepted Accounting Principles): A set of rules and guidelines that accountants follow to ensure consistency and accuracy in financial reporting. Example: GAAP requires that companies use the accrual method of accounting.
• Accrual Method: Recognizes revenues and expenses when earned or incurred, regardless of when cash is received or paid. Example: If a company provides services in December but receives payment in January, the revenue should be recognized in December.
• Matching Concept: Matches costs with revenues in the same period. Example: If a company sells a product for $100, the COGS should be matched with the revenue in the same period.
• Cost of Goods Sold (COGS): The direct costs associated with producing and selling a product. Example: If a company sells a product for $100, the COGS might be $60.
• Gross Profit: The difference between revenue and COGS. Example: If a company sells a product for $100 and the COGS is $60, the gross profit is $40.
• Debit/Credit Rules: Debits increase asset and expense accounts, while credits increase liability and equity accounts. Example: If a company buys $10,000 of inventory, the inventory account would be debited, and the cash account would be credited.
• Journal Entry Formula: Debits = Credits. Example: If a company buys $10,000 of inventory, the journal entry would be: Dr. Inventory $10,000 Cr. Cash $10,000
• Adjusting Entries: Entries made at the end of an accounting period to update accounts and ensure that the financial statements accurately reflect the company's financial position and performance. Example: If a company has accrued salaries of $5,000, an adjusting entry would be made to recognize the expense.

Journal Entry Examples

Example 1: Purchasing Inventory

Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The inventory account is debited to increase its balance, and the cash account is credited to decrease its balance.

Example 2: Accrued Salaries

Dr. Salaries Expense $5,000 Cr. Salaries Payable $5,000

Explanation: The salaries expense account is debited to increase its balance, and the salaries payable account is credited to increase its balance.

Example 3: Depreciation Expense

Dr. Depreciation Expense $2,000 Cr. Accumulated Depreciation $2,000

Explanation: The depreciation expense account is debited to increase its balance, and the accumulated depreciation account is credited to increase its balance.

Common Mistakes

Mistake 1: Confusing Debits and Credits for Expense Accounts

Correction: Debits increase asset and expense accounts, while credits increase liability and equity accounts. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to remember this rule.

Mistake 2: Not Recognizing Accrued Expenses

Correction: Accrued expenses should be recognized in the period they are incurred, even if cash has not been paid. Use the formula: Accrued Expense = Expense × Time Period.

Mistake 3: Not Matching Costs with Revenues

Correction: Costs should be matched with revenues in the same period. Use the formula: Gross Profit = Sales – COGS.

Exam Tips

Tip 1: Remember the Debit/Credit Rules

• Debits increase asset and expense accounts.
• Credits increase liability and equity accounts.

Tip 2: Be Aware of Reversing Normal Balances

• Reversing normal balances can lead to incorrect financial statements.
• Use the formula: Reversing Entry = Debit (Asset) × 2 = Credit (Expense).

Tip 3: Use the Matching Concept

• Match costs with revenues in the same period.
• Use the formula: Gross Profit = Sales – COGS.

Quick Practice

Problem 1: Accrued Salaries

What is the adjusting entry for accrued salaries of $5,000?

Answer: Dr. Salaries Expense $5,000, Cr. Salaries Payable $5,000

Explanation: The salaries expense account is debited to increase its balance, and the salaries payable account is credited to increase its balance.

Problem 2: Depreciation Expense

What is the adjusting entry for depreciation expense of $2,000?

Answer: Dr. Depreciation Expense $2,000, Cr. Accumulated Depreciation $2,000

Explanation: The depreciation expense account is debited to increase its balance, and the accumulated depreciation account is credited to increase its balance.

Problem 3: Purchasing Inventory

What is the journal entry for purchasing $10,000 of inventory?

Answer: Dr. Inventory $10,000, Cr. Cash $10,000

Explanation: The inventory account is debited to increase its balance, and the cash account is credited to decrease its balance.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. Debits increase asset and expense accounts, while credits increase liability and equity accounts.
3. Accrual method recognizes revenues and expenses when earned or incurred, regardless of when cash is received or paid.
4. Matching concept matches costs with revenues in the same period.
5. Gross profit = Sales – COGS.
6. Adjusting entries update accounts and ensure that financial statements accurately reflect the company's financial position and performance.
7. Reversing normal balances can lead to incorrect financial statements.
8. Debit/Credit rules: Debits = Credits.
9. Journal entry formula: Debits = Credits.
10. Accrued expenses should be recognized in the period they are incurred, even if cash has not been paid.