What is the accounting cycle?
A service business sells work, not goods: a tutor, a salon, a cleaner. Its money story repeats every accounting period (a month, a quarter or a year). The repeating steps are called the accounting cycle.
- Analyse the transaction from its source document (bill, receipt, bank slip).
- Journalise: write it in the journal as debits and credits.
- Post each line to its ledger account.
- Prepare an unadjusted trial balance.
- Record adjusting entries, then an adjusted trial balance.
- Prepare the financial statements: income statement, statement of owner’s equity, balance sheet.
- Record and post closing entries.
- Prepare a post-closing trial balance.
Steps 1–3 happen all through the period. Steps 4–8 happen at the end.
Generally accepted accounting principles (GAAP) in the cycle
GAAP are the shared rules that make accounts fair and comparable. Many countries now use IFRS (International Financial Reporting Standards); India uses Ind AS, which is based on IFRS. The ideas you use in the cycle are the same:
- Business entity: the owner’s personal money is kept apart. When the owner takes cash, it is drawings, not an expense.
- Time period: life is cut into periods, so we can report each one.
- Revenue recognition: record revenue when it is earned (the work is done), not when cash arrives.
- Matching: record an expense in the same period as the revenue it helped earn.
- Cost: record assets at what they cost.
- Objectivity: every entry needs a source document as proof.
Adjusting entries exist because of revenue recognition and matching.
Adjusting entries
Some accounts are out of date at period end. Adjusting entries fix them. Each one changes one income-statement account and one balance-sheet account. Cash is never in an adjusting entry.
- Prepaid expense used up (supplies, insurance): Dr Supplies expense, Cr Supplies.
- Depreciation of equipment: Dr Depreciation expense, Cr Accumulated depreciation.
- Accrued revenue (earned, not billed): Dr Accounts receivable, Cr Fees earned.
- Accrued expense (wages owed, not paid): Dr Wages expense, Cr Wages payable.
- Unearned revenue now earned: Dr Unearned revenue, Cr Fees earned.
Closing entries: manual and computerised
Temporary accounts (revenue, expenses, drawings) measure one period only, so they are emptied at the end. Permanent accounts (assets, liabilities, capital) carry on.
- Close revenue: Dr each revenue account, Cr Income Summary.
- Close expenses: Dr Income Summary, Cr each expense account.
- Close Income Summary (net income) to capital: Dr Income Summary, Cr Capital. A loss is the other way round.
- Close drawings: Dr Capital, Cr Drawings.
In a manual system you write and post these four entries yourself, then rule off the accounts. In a computerised system (Tally, QuickBooks, Sage, Zoho Books…) you back up the data, check the reports, then run the “year-end” or “close the books” command. The software moves net income to capital (often called retained earnings), sets temporary accounts to zero and locks the old period so it cannot be changed by mistake.
Key formulas and definitions
- Assets = Liabilities + Owner’s equity
- Total debits = Total credits (trial balance)
- Net income = Revenue − Expenses
- Ending capital = Opening capital + Investments + Net income − Drawings
- Supplies used = Supplies on the books − Supplies counted on hand
Worked examples
1. The owner invests 20,000 cash in a new tutoring business. Write the journal entry.
Assets go up and owner’s equity goes up. Dr Cash 20,000; Cr Capital 20,000.
2. Cash: +20,000 investment, +8,000 fees received, −2,000 rent paid, −500 drawings. Find the cash balance.
20,000 + 8,000 − 2,000 − 500 = 25,500 (debit balance).
3. Balances: Cash 25,500, Supplies 1,000, Rent expense 2,000, Drawings 500, Accounts payable 1,000, Capital 20,000, Fees earned 8,000. Does the trial balance agree?
Debits: 25,500 + 1,000 + 2,000 + 500 = 29,000. Credits: 1,000 + 20,000 + 8,000 = 29,000. Yes, both sides are 29,000.
4. Supplies account shows 1,000, but only 600 are left on the shelf. Write the adjusting entry.
Used = 1,000 − 600 = 400. Dr Supplies expense 400; Cr Supplies 400.
5. Fees of 600 were earned in the last week but not billed. Adjust, and find revenue and net income (expenses: rent 2,000, supplies 400).
Dr Accounts receivable 600; Cr Fees earned 600. Revenue = 8,000 + 600 = 8,600. Expenses = 2,000 + 400 = 2,400. Net income = 6,200.
6. Using the numbers above (opening capital 20,000, drawings 500), write the four closing entries and find ending capital.
1) Dr Fees earned 8,600; Cr Income Summary 8,600. 2) Dr Income Summary 2,400; Cr Rent expense 2,000, Cr Supplies expense 400. 3) Dr Income Summary 6,200; Cr Capital 6,200. 4) Dr Capital 500; Cr Drawings 500. Ending capital = 20,000 + 6,200 − 500 = 25,700.
Common mistakes
- Treating drawings as an expense. Drawings reduce capital directly; they never appear on the income statement.
- Thinking a balanced trial balance means no errors. A missed entry or a wrong account with the right amount still balances.
- Putting cash in an adjusting entry. Adjustments only move amounts between income-statement and balance-sheet accounts.
- Closing assets or liabilities. Only revenue, expense, drawings (and Income Summary) are closed.