The Accounting Cycle and Financial Statements: Study Notes

The Accounting Cycle

Introduction to the Accounting Cycle

The accounting cycle is a systematic process used by businesses to identify, record, and summarize financial transactions. It ensures that all financial events are accurately reflected in the company's financial statements.

• Assets (↑): Debit (Dr)

• Liabilities (↑): Credit (Cr)

Journal Entries

Journal entries are the foundation of the accounting system, recording each transaction in chronological order. Each entry must have at least one debit and one credit, maintaining the accounting equation.

• Example: Jane buys a house:

  • DR House: 1,000,000

  • CR Bank Loan: 800,000

  • CR Cash: 200,000

Accounts

Accounts track all activity within a specific category, such as cash, accounts receivable, or bank loans. Each account has a debit and credit side, typically represented in a T-account format.

• Example: Cash Account T-Account

  Debit	Credit
  200k	200k

Transaction Analysis and Journal Entries

Example: Techstart Inc.

Below are sample journal entries for a fictional company, Techstart Inc., illustrating common business transactions.

• Jan 1: DR Cash 9,000 | CR Common Shares 9,000

• Jan 1: DR Cash 10,000 | CR Bank Loan 10,000

• Jan 1: DR Equipment 16,000 | CR Cash 16,000

• Various: DR Cash 75,000 | CR Revenue 75,000

• Various: DR Cost of Revenue 12,000 | CR Cash 12,000

• Various: DR Insurance Expense 6,000 | CR Cash 6,000

• Various: DR Marketing Expense 14,000 | DR Rent Expense 12,000 | DR Salaries Expense 24,000 | CR Cash 56,000

Adjusting Entries (as of Dec 31)

• DR Dividends Declared 3,000 | CR Dividends Payable 3,000

• DR Revenue 5,000 | CR Unearned Revenue 5,000

• DR Marketing Expense 7,000 | CR Prepaid Marketing 7,000

Financial Statements

Balance Sheet (as at Dec 31)

The balance sheet presents the financial position of a company at a specific point in time, listing assets, liabilities, and equity.

Assets	Amount
Cash (Current Asset)	3,000
Equipment (Fixed Asset)	16,000

Total Assets: 19,000

Liabilities	Amount
Dividend Payable	3,000
Unearned Revenue	5,000
Bank Loan	19,000

Equity	Amount
Common Shares	9,000
Retained Earnings	7,000

Cash Account T-Account

Debit	Credit
9,000	16,000
10,000	12,000
75,000	56,000
	10,000

Income Statement

The income statement summarizes revenues and expenses to determine net profit for a period.

Item	Amount
Revenue	75,000
Cost of Revenue	12,000
Gross Profit (GP)	63,000
Salaries	24,000
Marketing	14,000
Rent	12,000
Insurance	6,000
Total Operating Expenses (OE)	56,000
Net Profit	7,000

Statement of Retained Earnings

This statement shows changes in retained earnings over the period.

• Beginning Retained Earnings: 0

• Net Profit: 7,000

• Dividends: 3,000

• Ending Retained Earnings: 4,000

Trial Balance

The trial balance lists all accounts and their balances to ensure debits equal credits.

Account	Debit (DR)	Credit (CR)
Cash	10,000
Equipment	16,000
Bank Loan (CL)		10,000
Bank Loan (LL)		9,000
Common Shares		9,000
Revenue		75,000
Cost of Revenue	12,000

Key Terms and Concepts

• Debit (Dr): An entry on the left side of an account, typically increasing assets or expenses and decreasing liabilities or equity.

• Credit (Cr): An entry on the right side of an account, typically increasing liabilities, equity, or revenue and decreasing assets.

• Journal Entry: The initial recording of a transaction in the accounting records.

• T-Account: A visual representation of an account, showing debits on the left and credits on the right.

• Trial Balance: A list of all accounts and their balances at a particular date, used to verify that total debits equal total credits.

• Financial Statements: Reports that summarize the financial performance and position of a business, including the balance sheet, income statement, and statement of retained earnings.

Formulas

• Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Equity}$

• Gross Profit: $\text{Gross Profit} = \text{Revenue} - \text{Cost of Revenue}$

• Net Profit: $\text{Net Profit} = \text{Gross Profit} - \text{Operating Expenses}$

• Ending Retained Earnings: $\text{Ending Retained Earnings} = \text{Beginning Retained Earnings} + \text{Net Profit} - \text{Dividends}$

Additional Info

• Adjusting entries are made at the end of the period to account for accrued and deferred items, ensuring that revenues and expenses are recognized in the correct period (accrual accounting).

• Dividends declared reduce retained earnings but are not considered an expense.