Welcome, in this video, I'm going to give you an overview of the accounting cycle. That's the bookkeeping process, and the way that it captures everything that goes on in a firm. As time passes, firms economic situations change. The accounting cycle captures these changes by several steps, thus creating the financial statements for the period. As companies interact with outside entities, the company's position changes. For example, imagine you're a company that sells books, and each time a customer comes in to purchase one of those books. When they leave with the book, that changes your company. Not only have they taken something, but they've left you something. Either cash or some sort of promise to pay etc. Another example, imagine you're still that book company and somebody shows up to deliver books for you that you're going to sell. When the truck pulls up and it drops those books off, now your company has changed. These interactions with outsiders prompt the company to realize that something has happened. The accounting process is then used to record the impact of each of these individual transactions. Thus, we analyze the impact on the company. We journalize these and we post each transaction as it occurs. Then we get back to work and we create more transactions. The important thing here is that there is some sort of an external prompt. It's interacting with that customer who buys the book or the supplier who drops the books off to you or any sort of other external prompt like that. Maybe, paying an employee etc. After we've cycled through a whole bunch of these interactions, we are going to get to the end of our accounting period. At the end of that period, management's going to need to review the books to see whether there's any sort of items they need to adjust. What they're looking for here is items where the underlying economics have changed, but there was no external transaction to prompt that accounting process we just talked about. For example, each time that you rang up a sale from that book, you're using that cash register and it can only be used so many times. After you've punched on it a couple times, it starts to wear out, and each punching wears it out a little more. During this adjusting process we're going to think about how much of that cash register did we use up, or we might have a whole bunch of accounts receivable from customers. We let them walk away with our merchandise, assuming that they would pay us. But the economic situation has changed. When we do this review, we may determine that in fact, we're going to have to adjust those accounts receivable because we're not really going to get paid. Each time that we figure out that we've got some sort of an economic change like that, we're going to follow the same accounting process. So we're going to analyze what does it mean for the company. For example we have a little less of that cash register, because we've used it up during that period. Once we figured out what's really happened, we are going to journalize it to capture it. And then we are going to post it to its accounts. So that it will be able to roll that all up into the financial statements in the future. We are going to review the entire balance sheet and income statement. And really think about the entire company to try to figure out what all adjusting journal entries need to be made. Once we finish those, it's time to do what's called closing the books. And we're going to do that using closing entries. We're going to start with our temporary accounts. You don't know what those are yet, let me explain. All those revenue and expense accounts that we use as we're recording transactions in the company? Remember, they helped to answer that second big question in life: what happened over this time period? Because of that they need to start with a zero balance at the beginning of the period and then accumulate activity over the period. So what we need to do at the end of each period is close those out to get them back down to that zero balance. That is actually why we call them temporary accounts. They are temporary to this period, then we're going to reset them to zero, and start over again in the next period. So what we need to do with all those temporary accounts is, take out the net impact of everything that's happened during the period. The best way to make a clear, let me just show you. So let's take a look with a t-account, let's think about our revenue account. We make a sale during the period, like any sale, we credit out revenue account. Say that sale was for $1,000. We make our next sale for $1,700, we make another sale for 800. Now hopefully, we're going to make way more than three sales, but this is enough to illustrate our point. So we've been recording each of these as the transaction occurred. Back in that first step, something external has prompted us to think that there's a transaction here. When we add it all up, we have $3,500 worth of sales. That's going to be our total activity in this temporary account for this period. Remember, our goal is to get it to zero. If we have a $3,500 credit balance, how do we get the t-account to zero? We put in a debit of $3,500. Now when we sum the two up, we've gone to 0. Now if we put a debit of 3,500, there has to be an outstanding credit somewhere and we're going to come back to that. Let me show you another account, we'll use an expense account to see the same thing. Again, as sales are made, there is an external prompt that something is happening to the company. So when the first sale was made, if it cost us $500 to have made that sale. We'll record that as a debit because it's an expense. And when the next sale's made, it costs us 850, so we'll record that as a debit again. And yet the third sale cost us $300. When we sum that all up, we have $1,650 worth of cost. That's a debit balance. Just like with the revenue, we want to get this to zero. In this case we have a debit balance of 1,650, so we need to get that to zero. We're going to need to put in a credit of 1,650. Now of course you're asking yourself where did all those debits go? And when we come back where all those credits went, we'll also talk about where those debits go. But we're not quite there yet. The important thing here is, we've gotten this account to zero. And we'll go through and do this for all of our temporary accounts, getting all of them to zero, and summing up the net impact of all their credits and debits. Then we're going to move onto our permanent accounts. Remember the assets, liabilities and stockholder equity accounts? All of those are answering that first big question in life, where do we stand at any given point in time? Well, in order to do that, what we do is take all the activity over the year and we add that to the beginning balance. That's going to get us to the current position of where we stand at any given point in time. That's why we call them permanent accounts. They give you a permanent history of everything that's happened in this account. So, unlike the temporary accounts that we're trying to reset every period. For these, we let that history just continue to run, and when we hit the end of a period, we just add up where we are right now, and that's the account balance that we're going to use to make the financial statements. Now there is one special permanent account. The retained earnings account. It's a balance sheet account, and so it's a permanent account just like the other ones we've talked about. But it's special in the closing process. The net balance for all of those temporary accounts that we've talked about is usually not zero. In some cases the revenue is going to be greater than the expenses like in the example that I've given you. And that means that we've created net value over the period. In other cases, the expenses may actually exceed the revenue. In those situations, we've actually destroyed value over the period. Whichever one happen, we want to take the net impact of closing of all those temporary accounts and we're going to add that into the retained earning balance. So that it's going to sum up to to our closing retained earnings, our final balance there. This is called the articulation of the financial statements. You'll hear people use that term a lot, but they don't define it. What we're saying these financial statements articulate is just a fancy way of saying, we're showing how all of the impact from the changes that the income statement capture this period get netted over to impact the balance sheet. And that articulation takes the net impact of the income statement and puts it over into the retained earnings account. Is that clear? While again, I think a t-account is going to make that a lot clearer for you. So let's imagine that our firm started the period with the retained earnings balance of 42,000. That's the history of everything that's ever happened in this retained earnings account for this company. Remember that $3,500 of revenue that we had come in? But then it cost us $1,650 to generate that revenue. To keep the example really simple, we're going to imagine that there aren't any other expenses. So that, in total, we've created $1,850 of value for the company. Now if you think back to where we debited the revenue account for that 3,500, and I said to you, where did all those credits go. Well, here they are. This is the 3,500 of credit. And when we zeroed-out our expense account the 1650 by putting a credited net T-account, and I said now where do all the debits related did they go? Well they go right here. So the net of the 3,500 credit balance in revenue and the 1,650 debit balance in the expenses tells us that we've got a credit balance of 1,850. Where do we put that net credit balance? We're going to put it in the retained earnings account. In fact we're going to add it right here. That gets added to the beginning balance to say we have retained earnings of 43,850. Now had we paid out dividends during the period? We would have debited the retained earnings balance. But what I want you to see here is the way we articulate over that net impact of the financial statements and add it into the retained earnings. Okay, once we've done that, we're actually all ready to create our full set of financial statements. We've zeroed out all of our temporary accounts, we've added up all of our permanent accounts. Now all we need to do is know how to put them together to make those statements. The balance sheet is going to be built just by taking the ending balances of all those permanent accounts. And the income statement is going to be built by looking at the detail of the temporary accounts. That detail that we've zeroed out, and putting that intothe income statement. What we're going to do is just put those into the proper format for each statement. So for the balance sheet, we'll put all the assets together, the most liquid ones first. We'll put all the liabilities together, the ones that we're going to have to pay off first go on top. We'll put the equity accounts together. For the income statement, we're going to format it so that we've got revenue at top, and then the different categories of expense broken out to finally come down to our net income. Now, before we move on from this, I've covered a lot of details so I just wanted give you a quick review of the accounting cycle. The first step in the accounting cycle is that we do the externally prompted transactions. We're going to have things happen in the company that's going to let us know the company's change. We're going to use the accounting process to record those on the company's books. Once we get to the end of the period, we're going to review our books to look for adjusting journal entries. Those are the sort of things that economically have changed the firm, but we weren't externally prompted to have to make a change to the company's books. Once we've adjusted the journal entries completely, we're ready to do the closing entries. We're going to zero out our temporary accounts, we're going to sum up our permanent accounts. And we're going to take that net change from our temporary accounts, bring that over to retained earnings before we sum up retained earnings. Now that we've done all of that, we've got the easy part ahead of us. We're going to create a full set of financial statements. That's just taking all of those accounts that we've already closed out, and putting them into the right order, so that we can create a set of financial statements, so they are most useful for external users. All right, one more thing to keep in mind before we move on. I've talked a lot about the accounting process and the accounting cycle. I don't really want you to get too caught up on that verbiage, it doesn't really matter what we call these things, but in particular the accounting cycle, it's a word you are going to hear a lot. If you've ever taken intro accounting before, every textbook in the world begins with this accounting cycle. And spends the first couple of chapters working through the accounting cycle. So let me just clarify the difference between the two for you, just so that it will be helpful for your thought process as we move forward. First of all, the accounting process record the impact of a single transaction on the firm. The accounting cycle, on the other hand, captures the evolution of the firm over time. It aggregates up all of those single transactions over the period. Then when you define the reporting periods, you use that to create financial statements for that period. That means the accounting process is actually a part of the accounting cycle. We're going to do the accounting process over and over again in any one given accounting cycle. I hope this video has clarified the accounting cycle for you, helps you understand the parts. We're going to have other videos to focus on each one of those parts individually.
